In this edition, I detail a research paper arguing that certain passive investment instruments might be set for problems. A recent cybersecurity conference highlighted strong growth opportunities and the diversion discusses the psychological roots of conspiracy thinking. We’ll also look ahead to the (very few) important data releases in the upcoming week.
A trader watches his monitors on the floor of the New York Stock Exchange.Richard Drew/The Associated Press
ETFs
Have passive investors gone too far?
Citi strategist Chris Montagu highlighted a new academic paper by Campbell Harvey, a Duke University professor of finance, and Chris Brightman of Research Affiliates, emphasizing the risks for investors caused by ETFs that track market cap weighted indices like the S&P 500.
Mr. Montagu and Mr. Harvey can be accused of talking their book here, warning investors away from low-fee ETF investing that limit returns for their firms. But it’s also the case that I can’t think of a single instance when a change in market structure this large didn’t lead to significant upheaval.
The paper is called Passive Aggressive: The Risks of Passive Investing Dominance. The authors begin by conceding the success of index investing was entirely justified by low fees, diversification, simplicity and performance. But they argue passive investing specifically in market-cap weighted indices has now become a victim of its success. Unintended and unwelcome consequences are now apparent.
The trillions of dollars parked in index-tracking instruments have twisted the market out of shape. Stocks now “co-move,” meaning they rise or fall in the same proportions, to a far greater extent than before the popularity of index funds. This implies poor price discovery as new funds invested in passive funds are allocated without reference to stock fundamentals. The more funds are allocated to passive vehicles, the greater the misvaluation becomes, particularly in the form of the big market-cap stocks getting bigger.
Companies are often not rewarded for superior performance in market-cap weighted index funds. Instead, the stock prices just keep moving with the rest of the market. This is true even for companies with vastly different business models. Stocks outside the index are frequently ignored no matter how attractively valued or profitable.
Mr. Harvey and Mr. Brightman found that the dominance of passive products increasingly makes them one co-ordinated trade – selling in one fund cascades into selling in others. The risks climb of a “synchronized liquidation” in markets with assets in passive funds. In a section of the paper called Fragility from Synchrony the authors write: “Empirical evidence shows that stocks with higher passive ETF ownership exhibit greater exposure to aggregate liquidity shocks, making them particularly vulnerable during market downturns when liquidity is most needed.”
The research paper recommends investing in equal-weighted index ETFs like the Invesco S&P 500 Equal Weight Index ETF instead of the conventional market-cap weighted index. This will protect assets in the event of a mass revaluing of mega-cap stocks. The authors note that from 1995 to 2005 – the period encompassing the expansion and implosion of the tech bubble – the equal-weighted S&P 500 index outperformed the conventional benchmark by 13.6 per cent annually to 11.4 per cent. They also recommend ETFs that favour stocks with low valuations like those mirroring the returns of the Russell 1000 Value Index.
Market history is full of good ideas that were taken too far and caused big problems for investors. Portfolio insurance was fine in theory but caused the crash of 1987. Credit default swaps were a useful instrument initially but eventually formed the root cause of the great financial crisis. Going back deep into the past, the advent of the Joint Stock Company in the early 18th century – the issuance of shares – was taken to extremes and resulted in the South Seas Bubble. Just because passive investing in cap weighted indexes is a good idea doesn’t mean it won’t lead to problems.
The New York Stock Exchange.Seth Wenig/The Associated Press
Tech
Cybersecurity demand still strong
BofA Securities analysts presented 17 sessions with cybersecurity executives at BofA’s recent Global technology Conference in San Francisco. Analyst Tal Liani summarized the major takeaways for investors in a Monday report. Mr. Liani also used the report to announce an increase in the price target for Zscaler Inc. (ZS-Q) from US$285 to US$340.
A look at Radware’s live threat map, which tracks hacking attempts on government and corporate networks in real time, clearly underscores the widespread persistence of the problem. The site’s global map shows the origins and targets of hundreds of ongoing attacks. It’s no surprise then that cybersecurity management at BofA’s conference emphasized the strong demand for their expertise.
The First Trust NASDAQ Cybersecurity ETF is one of the longest-standing vehicles for investment in the theme. Performance for the ETF have been impressive – an average annual return of 11 per cent over ten years, 17.4 per cent for five years and 22.6 per cent over the past three years.
Returns for largest holdings in the ETF have been eye popping. Top holding Broadcom Inc. has jumped 67.2 per cent annually over the past 36 months. CrowdStrike Holdings Inc. average 38.8 per cent for the period and Palo Alto Networks Inc. rose 31.6 per cent on average.
Diversions
Overconfidence the key to conspiracies
Researchers from the University of Regina, Cornell University and M.I.T. attempted to identify the psychological motivations for conspiracists. They found that overconfidence plays a major role.
After testing roughly 4,200 adults, the study found that “conspiracy believers consistently overestimated their performance on numeracy and perception tests.” The professors also found that conspiracy believers were hugely delusional about how many people agreed with them. Conspiracies were believed by 12 per cent of those studied but believers assumed they were in the majority 93 per cent of the time.
The essentials
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The Rundown
J.D. Power recently completed a customer satisfaction survey for banking apps in Canada. The bank that took the top spot may surprise you, writes Rob Carrick.
Rob also has a rundown of what Canadian investors need to know about proposed changes to U.S. tax law.
Income inequality is a crucial issue for economic and political stability, says David Rosenberg. So why is nobody talking about it?
What’s up next
The calendar remains light for both domestic economic reports and corporate earnings releases. Manufacturing sales results for May will be reported on Friday and economists expect a 2-per-cent month over month decline. International securities transactions will be detailed in a release next Tuesday and it should provide insights into the attractiveness of domestic assets relative to U.S. investments.
The only earnings release of note is Dollarama, which reported $0.98 per share in net income Wednesday morning compared with $0.835 predicted.
U.S. CPI for May was reported Wednesday morning, and the 0.1-per-cent month over month reading fell short of the 0.2-per-cent forecast. Producer prices will be reported Thursday and economists expect a 0.2-per-cent month over month increase for May.
Industrial production will be reported next Tuesday and a 0.1-per-cent increase for May is predicted. The Federal Reserve will announce its decision on policy rates next Wednesday and no change in rates is expected.
See our full economic and earnings calendar here (You can bookmark the page – it gets updated weekly)
