In a recent report, an analyst at INTL FCStone (INTL, Financial) found clear signs that the market may be in the throes of a passive investing bubble. We discussed the report in a research note last month, including one of INTL’s most distressing findings:
"The INTL report points out that the average US stock is part of 115 indices. That is not terribly interesting in and of itself. This is the real kicker: Stocks in more than 200 indices are 2.5 times more expensive than stocks in fewer than 75 indices.
So stocks that are in high demand among indices are more expensive than those that are not. But what does that mean? For one thing, it indicates quite clearly that index fund composition and design is genuinely impacting stock prices."
Indexes have become the elephants of the stock market, and their composition and behavior is moving the market in material ways. In that same research note, we suggested that investors look to value stocks, especially deep value stocks, as a powerful strategy in light of a high-priced stock market with many big stocks bid up massively by insatiable index fund demand.
As an alternative to that, the INTL report offers what it calls an “anti-ETF ETF” as a way to obtain a market-like return while avoiding the price inflation of mainstream ETFs. Let’s take a look at the concept and whether it has merit.
Introducing the anti-ETF ETF
INTL offers this explanation of the anti-ETF ETF:
"One measure of the value, or lack thereof, provided by index providers is to compare the performance of the stocks they chase versus the ones they deem unworthy. I have followed this approach with the 'DUMB beta ETF,' a fictional fund that invested in the deplorable stocks snubbed by the major 'smart beta' ETFs. Almost two year after its launch, there is no indication that my 'dumb' stocks perform any worse than their supposedly smart counterparts.
This contrarian approach can be replicated even for so-called passive funds because the mostly-followed benchmark, the S&P 500 index, is not purely market-cap weighted."
By focusing on impressive companies that do not fit into current ETFs’ criteria, it may be possible to construct an index that can outperform other market-tracking indices and ETFs, and at lower cost.
Testing the hypothesis
INTL’s analyst did a back-dated test to see if the hypothesis held:
"How did this basket of deplorables perform over time? Using Bloomberg’s backtest function (EQBT), I found that large stocks that were excluded by the Standard and Poor’s committee underperformed by 50% since 1995. Of course, causation could run both ways: maybe the Standard & Poor’s requirements eliminated poorly-performing companies. Or maybe being excluded from the most popular indices in the age of the index fund caused these stocks to underperform.
Whatever the reason, the effect seems to be waning: index dropouts have actually slightly outperformed the S&P 500 index since January 2016."
INTL shows that, at first, the basket of stocks that had been excluded from conventional index funds and ETFs for various reasons, such as insufficient float or lack of profitability, did underperform for a long time. That makes sense, since there are often good reasons for excluding stocks from an index, or for a stock to drop out. Before the massive growth of index funds began to bid up the prices of incorporated stocks too high, they were probably more efficient. Now, with so much money flooding to passive allocations, that efficiency is gone and many included stocks have been bid up to rarefied levels.
The flood of capital into the passive space has finally changed things. With dropouts from indices now outperforming their index brethren since 2016, we may be witnessing an early sign of a fundamental change in passive investing dynamics and performance.
Verdict
According to INTL’s analysis, the stocks excluded from indices underperformed their index-held peers between 1995 and 2015, and have still done so in aggregate terms. But that lead has been shrinking, with 2016 appearing to be a sort of inflection point, as dropouts have started to outperform their index peers. A 20-year trend cannot be erased by a few years’ worth of data. But it is yet more evidence that a passive bubble has indeed emerged. With passive investing still in vogue, the bubble is likely to continue – until something big disrupts it. Then the whole market is likely to reel.
While the INTL report offers an intriguing little experiment in constructing an anti-ETF ETF, it may well provide a means of undertaking a passive strategy without having to take positions in over-bought, over-indexed securities. But it is far from perfect. The stocks floating outside of indices may not be bid up to the extent of the broader market, but most stocks have enjoyed the boons of the long bull market. While they look like a perhaps more efficient way of doing ETF allocation at this moment, it is more a response to irrational behavior in index funds, not a testament to these unindexed stocks’ particular merits.
Thus, we stand by our initial recommendation on the basis of INTL’s findings: Look for value and deep value opportunities. They may be few and far between these days, but they exist. And they offer a surer defense against a passive bubble bursting than do ersatz anti-ETF ETFs.
Disclosure: I/We have no positions in any stocks discussed.
