The Bottom Line
- “Passive”, index-based vehicles have their uses, but also distinct built-in biases.
- Case in point: the impact of weighting stocks by market-capitalization, as practiced by leading equity indexes like the S&P 500.
- Nowhere is that more obvious now than in the expansion of the technology sector, thanks to the run-up in mega-tech stock prices.
- When a narrow group of stocks is in demand, as mega-tech has been, their price gains result in them being a bigger part of the index. But what goes up can go down, and the result can be heightened exposure to downside risk as they become a bigger and bigger part of a portfolio.
- Consider how the S&P 500 index’s composition has changed since the end of Q3 2016.The closely-watched Information Technology (IT) sector’s share of the index has moved up over four percentage points, to a peak of 24.8% on November 24, 2017.1
- In contrast, the broad-based Consumer Staples (CS) sector dropped about 2 percentage points since the end of Q3, down to a low of 7.8% of the S&P500 on November 6, 2017.
- The widest disparity between the weights of the two sectors was a sizeable 16.9 percentage points, on November 6, 2017 – before the sell-off in the IT sector at the end of November.
- One effect of the disparity: on November 6, the top three stocks in the IT sector accounted for 8.91% of the S&P500, 3.6 times the weight of the top three stocks in the CS sector (2.49%).
- The bottom line for investors is that a downward move in a fashionable sector can cause many times the damage of the same downward move in a significant, but smaller sector.
- All of which underscores the potential benefit to investors of having skilled active managers who can make allocation decisions unaffected by the accumulated biases – or potential for downside errors – embedded in supposedly unbiased cap-weighted “passive” indexes.
1 Source: Bloomberg, December 7, 2017.