Weekly update - Is index investing creating a dangerous feedback loop?

Whether we choose to invest through stock pickers or via indices, it is important to think about where your money is going. With indices highly concentrated today how much should you bet on a single trend? If you buy an S&P 500 tracker for example, a third of your money¹ goes to seven large tech stocks which are all exposed to a similar set of risks. Asking ourselves if we are comfortable with that is an important question, however we choose to invest.

Everywhere we look we are being told that we shouldn’t fight the power of the market. The old-fashioned world of stock pickers is dead, and we should simply buy the index at the cheapest possible fee rate and let nature take its course. While we use passive funds in certain circumstances, the general argument that thinking about what you own is outdated has never sat well with us. Surely it isn’t prudent, as people entrusted with our clients’ hard-earned money, to simply throw that money at whatever stocks conform to an arbitrary set of rules that define an index.

The headline numbers, though, seem to make the case for doing exactly that. In the long term, we are told most stock pickers underperform the index trackers after fees. But is that true? Well, it depends on where you look. In short, beating the market in US equities is tough, it’s doable in bonds and other markets sit somewhere between those two extremes. 

For example, if you take the Investment Association Sterling Corporate Bond² sector and you take the funds that have a general mandate (removing specifically short-dated bond funds for example) and have been running for a decent amount of time (say 10 years) you get 54 funds. Of those funds over the 10 years, roughly six out of 10 have beaten the passive options, from the likes of Vanguard and iShares. Notably, even the worst laggard was only behind the passives by -1% per annum. This makes some sense as indices make much less sense in bond land. Why would you lend the most money to the firm with the most debt? It just doesn’t make a huge amount of sense when you think about it.

Unfortunately for active managers, the same is not true for US equities, which are probably the toughest space due to intense competition. Here, if we take the Investment Association North American Equity² sector and filter out the newer funds (less than 10 years of history) and those with passive or very specialised mandates, we are left with 100 funds. Of those, about eight out of 10 have lagged the index and the worst of those has done so by around -8% per annum. Ouch! For the man on the street, the case for sticking with an index tracker seems solid here and even die-hard stock pickers would concede that US equities are a tough space to outperform in with a fee headwind.

This extreme level of outperformance of index tracking in the equity space, however, is noteworthy in itself. A huge amount of money has shifted from stock pickers to index trackers over the past decade or so. But how much? Well, take just one big ETF as an example:

The Vanguard S&P 500 ETF³ alone is now over a trillion dollars!

There is a risk that this weight of money flowing into funds that all own the same stocks funnels money into the biggest names in the index. Those stocks then outperform, which draws in more money via the weights of these stocks rising in the index and by passive index trackers outperforming more diversified stock pickers. This type of feedback loop is what George Soros might call reflexivity, where strong asset performance strengthens the case for further investment. This is illustrated in the diagram at the start of this article and, crucially, works in both directions. We saw this with rising property prices in the run-up to the 2008 global financial crisis, for example. As long as property prices rose, leverage ratios improved, and equity buffers grew, allowing further investment, which in turn drove prices higher again.

The danger of reflexive feedback loops is that they work in both directions and while they tend to rise in long gradual upswings they tend to unwind violently.

It is this potential for a violent unwinding that worries us – if a passive feedback loop is indeed driving market behaviour today. Is this happening today? If it was the case, you would expect to see:

•  A small number of stocks dominating the indices
• Those same stocks driving the bulk of stock market returns
• Index funds outperformed more diversified stock pickers

Worryingly, this is of course exactly what you do see today. If you buy the iShares Core S&P 500 ETF¹ today, then around a third of your money would be funnelled into a small number of big tech stocks:

Source: iShares.com

And while these are amazing businesses at the cutting edge of some key technologies, they are all exposed to the same underlying risks. What if everyone has got ahead of themselves on issues such as:

1. The chances of competitors emerging and disrupting the current winners
2. How quickly profits will follow from expensive investment in generative AI

After all, Microsoft was at the cutting edge back in 1999, but that didn’t stop the stock halving in the early 2000’s and then going nowhere for a decade⁴.

I think a big risk today is that in the rush to keep up with a strong stock market, we risk forgetting to think about the basics. Simple questions like, is it prudent to bet a third of my portfolio on a single hot trend?

Active managers mustn’t stick their heads in the sand; failing to adapt to genuine change can be a costly mistake, but failing to spot that you might be rushing into a crowded trade could be just as bad, especially if it comes as a nasty surprise during a sudden turn in the tide.

Sources:

1. iShares Core S&P 500 ETF
2. Investment Association data as compiled by FE Fundinfo and Ravenscroft calculations. Date range 10/07/2014 to 10/07/2024 in Sterling total return terms net of fees. Collated 11/07/2024
3. Vanguard S&P 500 ETF
4. Google Finance