A Weighting Problem
Key Takeaways
Index investing (and its related products — ETFs) have grown in popularity due to its ability to access a globally diversified portfolio at a relatively low cost.
Keeping it cheap means that trading within the fund is kept to low levels i.e. rebalancing only once or twice a year. The infrequency, combined with the rigid metric for how rebalancing is carried out, can result in diminished returns or even losses.
Keeping an open minded perspective and approaching each strategy’s pros and cons holistically enables us to capture the best of all worlds - be it passive, traditional active, or asset class investing.
Be careful when you blindly follow the masses. Sometimes the ‘M’ is silent.
— Unknown
Index investing has grown in popularity over the last decade and more — the fallout of the 2008 Financial Crisis accelerating its rise. Its use is logical; the premise being founded on the basis that since most fund managers fail to outperform the market, the optimal way to invest in a diversified portfolio is to track well-known and popular indices, such as the FTSE All-World Index or S&P 500 Index, while minimising costs and fees.
Because the primary purpose of index investing (and its related products — ETFs) is to ensure that fees are kept low, trading and turnover within the fund is kept to low levels. As such, indices, and consequently the products that track these indices, are typically rebalanced once or twice a year.
The significance of rebalancing
The rebalancing exercise is essentially a decision making process to determine which stocks meet the appropriate criteria to be included into the index and which ones get kicked out.
Unless you are a data geek or have an interest in how indices are constructed, you may not be aware of the many nuances underneath this filtering, some of which are driven by the goal of minimising taxes and diversification constraints. (Index construction methodology by S&P can be found here.)
For instance, on 21 June this year, the S&P Technology Select Sector Index (and its associated investment products tracking it) executed its annual rebalancing exercise. To maintain regulated investment company tax treatment, the combined weight of security positions with at least 4.8% weight in the index cannot exceed 50% in totality.
So when the group of Microsoft, Apple and Nvidia breached this limit in 2023, the result was that both Microsoft and Apple were held in the appropriate percentages, while Nvidia, being the smallest market cap, amongst them was then held in an amount to make up whatever was needed to reach 50%.
During the June 2024 rebalancing however, between Microsoft, Apple and Nvidia, Apple turned out to be the smallest market capitalisation of the three. As a result, its weight was trimmed and given to Nvidia. (see diagram below).
This shifts may not seem out of place — after all Nvidia has been one of the best performing stocks in the world. But factors like when and in what proportion you hold each of these stocks can lead to significant changes in rates of return. When you compare the performance of the three stocks from Jan up to the rebalance date you will notice that Apple had a lacklustre first 6 months compared to Nvidia (shown in the graph below). Thus, by holding the passive vehicle tracking this index, your large holding in Apple and very small holding in Nvidia would contribute to a possibly large opportunity cost in lost returns.
Making matters worse, if we look at the performance of those same stocks after rebalancing, it is interesting to note that now the reverse is happening. After a large allocation to Nvidia and small allocation to Apple was made respectively, it now appears that Nvidia is performing much worse than Apple. In holding this passive vehicle, an investor would have missed out on the returns for Nvidia, only to buy it back to eat its losses.
The loss and cost of rigidity and scheduling
What happened was that for passive investors, they may have held the wrong amounts of both stocks at the wrong time — resulting in a bit of a double whammy.
Now, we do not know whether this will continue indefinitely and how many times this whipsaw has occurred in the past, but this example serves to highlight some disadvantages of index investing that everyone should be aware of.
Index investing does not allow for a systematic and dynamic process — once a stock becomes overvalued, it starts to carry more weight in the index and vice versa. Logically, when stocks rise in prices, we should gradually trim and lower the portfolios' exposure to that stock. Conversely, when stocks are cheap relative to peers, evidence shows that we should increase our exposure to it in order to boost long-term returns. Index investing does not incorporate these principles.
Incorporate what works
However, we are not saying that index investing is bad. As always, it is not a clear cut case without its nuances. By knowing the pros and cons of each approach — passive, traditional active, and asset class investing, we would be able to utilise the best of each and every approach when we create a portfolio to achieve long term goals.
As such, we prefer to be flexible in our investment decisions and weight investments according to what are our client’s desired outcomes for risk and return. If you would like to find out more about the portfolio construction process and what it can do for you, come and have a chat with us.
