The trouble with index investing

Alex Pollak

The Name of the Rose is Umberto Eco’s masterpiece whodunit set in a 14th century monastery (bags of sex and grisly violence with some serious semiotics thrown in). The last line of the book, which is a reference to the title, has been translated from the Italian as "Yesterday's rose stands only in name, we hold only empty names."

Just like index investing.

How?

Index investment was developed to offer an efficient investment tool to capture the breadth, depth and evolution of industry sectors. Companies are classified quantitatively and qualitatively. Each company is assigned a single classification at the sub-industry level according to its principal business activity. Revenues are a key factor in determining a firm’s principal business activity.

Fair enough. But by this definition, Facebook, which derives its revenues from advertising, should be considered a media play. So should Google. According to GICS*, which is one of the main classification systems used, they are both in Information Technology.

Why does this matter?

An active global manager will mostly approach the whole question of portfolio construction from the perspective of index weights. This has resulted in the manager using sector index weighting as an anchor, with some percentage variation in exposure but rarely taking a significant position above or below this.

Similarly, a global index manager doesn’t just cherry-pick a few names, but buys many or even most of the companies in the index basket. So as well as the outperforming companies like Facebook, it is highly likely that the manager will have bought underperformers like New York Times, Viacom and the like. These companies have been hammered by the disruption which has taken place in ad-tech, with Facebook and Google now the largest advertising companies in the world, having crushed traditional media companies.

When Amazon first listed twenty years ago, it was not included in retail. A global index investor would have held a much larger weighting in other retailers including Walmart and Macy’s, which have dramatically underperformed Amazon.

Global investors (meaning most smsf’s using a global manager which is index-based) using portfolios constructed along these lines would have underperformed those which considered the true nature of the business in which they were invested. Names matter, as Mr Eco says.

The trouble with disruption is that it is no great respecter of GICS classifications or even investment styles. Apple (information technology) has torched the value of telco’s (GICS classification telecommunication services ) around the world in the past ten years, laying waste to landline revenues and then scooping up buckets of money providing high-bandwidth value-added services like video streaming.

Agreed, this is backward looking, but the learnings from it form an integral part of where we go from here. For example the manufacturing component in the electric car is radically reduced. Clutch assemblies, gearboxes, turbos – all these components are not required, with estimates of more than a 60% reduction in the number of parts. Should an investor hold GICS ‘Automobiles and Components’ at sector weight, because if that were the case it would mean owning Ford, GM and Delphi. In the GICS classification energy are companies like oil company Exxon, and formerly Peabody Energy (which recently emerged from chapter 11, having entered bankruptcy last year).

Software is taking over the functions of whole classes of machines, hollowing out manufacturing. The compact disc, dvd player, newspaper and film camera have all fallen to software. Same with the phone. Traditional retailing is falling, transport too, with software helping - then maybe replacing - the driver. The issue is that disruptive software has replaced the IT industry, and is now wreaking havoc on the physical world of retailing, banks, energy and transport.

Should a company developing software to replace physical products and services be included in software? Or should it be considered relative to its functional definition, meaning the sector which it is supplanting?

When a customer buys from Amazon, are they buying technology, or a box of nappies?

We can see the subtleties of arguments in favour of inclusion in GICS sectors different from those in which the companies are currently shown - indeed, even the Harvard Business Review has picked up on it, saying “even though these systems are updated regularly, we can no longer rely on standards and measures that were developed in a different age to reflect today’s realities”. And we wouldn’t really care, one way or the other, except that investing today absolutely demands accuracy and specificity if return is to be effectively harvested.

So when investors ask whether we have hit peak technology valuations, our response is that the companies doing the disrupting are making their way into sectors previously considered safe, like transport and energy - markets much bigger than the ones they have disrupted.

The related question is why not simply invest in an index etf? The first answer to this question is that without the understanding of what is happening in global business, how would an investor even be able to make a choice about which etf to buy? As for taking a position in a technology etf as a means of taking advantage, not all the disruptive companies which are powering so much value creation are in the IT sector, for example Tesla.

As an investment, a rose must actually be a rose. Otherwise it is just an empty name.

For further insights from Loftus Peak, please visit our website

*Global Industry Classification Standard


Comments

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David

Your article is extremely biased. You forgot to mention that if you held the S&P 500 index, and a stock was dropping outside the top 500 the stock that took its place would be captured in the index. Thereby you wouldnt need to find the next Amazon or Apple the index would do it for you.

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Muditha Weeratunga

I think the better option is to find customized ETFs (eg. MOAT , QUAL, HACK) . Lower fee than a manager and still get some kind of active beta returns.

Medium alex pollak   hi rez constantinvestor

Alex Pollak

Whether etf or active, the better option is to choose the product which provides the higher risk adjusted performance, net of fees.

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Carlos Cobelas

whilst I do like high quality active managers that outperform the index consistently, there are just too few of them, hence the popularity of ETFs which have much lower fees. Fund managers only have themselves to blame for it. Didn't Warren Buffett recommend that most people are better off just holding the S&P500 index ?

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