Interactive Investor

US tech rally is double-edged sword for market-cap ETF investors

5th August 2020 14:52

Tom Bailey from interactive investor

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As US tech giants reach new highs, the positives and negatives of market-cap weighting becomes clear.

In mid-February, The Economist had a front cover with the headline “Big Tech’s $2trn Bull Run.” For some, the appearance of a strong-performing asset class on the front page of a magazine is often seen as a sell signal, a potential sign the market is reaching its peak.

Those bears, however, have since been proven wrong. On 3 August, driven by gains from Microsoft and Apple, the Nasdaq Composite index reached a new all-time high.

Part of the appeal of such companies is based on the idea that their business models are more immune to the economic fallout of Covid-19. On top of that, growth stocks generally benefit when interest rates are low, with their future earnings increasing in present value.

Whatever the primary driver of tech’s continued bull run, these stocks have far outperformed the rest of the market, sending their size (market capitalisation) to new heights.

There are several ways of expressing the size of these companies compared to other equities. Apple, Microsoft, Amazon and Alphabet have a combined market cap of around $6 trillion, bigger than the entire Japanese market. Looked at another way, the five largest stocks on the S&P 500 index, Apple, Microsoft, Amazon, Alphabet and Facebook, now represent over a fifth of that index. The previous time the biggest five stocks reached that level of concentration was the 1980s.

This strong rally of already strong-performing tech stocks has generally meant good news for index fund and ETF investors. Any ETF tracking a market capitalisation weighted index will have started the year with an already high exposure to the five large tech stocks and therefore a high exposure to their steady gains.

However, while the continued strong performance of these stocks has been a blessing to ETF and index fund investors, it does highlight one of the major risks of tracking the index on a market-cap weighted basis.

How market-cap weighting works

First, a recap of some basic definitions. A company’s market capitalisation is the total market value of its publicly listed shares. This is worked out by multiplying the number of shares in circulation by the price of each share. So, a company with 100 shares trading at £10 each will have a market capitalisation of £1,000.

If there were two companies in a market-cap weighted index (Company A and Company B) both with a market cap of £1,000, the index would weight them at 50% of the index each. However, if the share price of Company A doubled, its market cap would grow to £2,000. Assuming Company B’s share price stays the same, the market cap of the entire index would reach £3,000. As a percentage of the index, company A, with its £2,000 market cap, would equal 66% of index, while company B would now equal roughly 33% of the index.

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When it comes to real-life indices, there are usually somewhere between a few dozen and thousands of constituents, so the maths is much more complicated. But the principle is the same: if a company’s share price goes up relative to other members of the index, it will represent a higher percentage of the index.

For ETFs and funds that try to replicate a market-cap weighted index, that means greater exposure to what has gone up. In the case of our fictional index composed of Company A and Company B, an ETF tracking that index would now have 66% in Company A and just 33% in Company B. Likewise, when Amazon goes up in value compared to other stocks in the index, the ETF has a greater exposure to Amazon shares. 

The best-case scenario of anyone holding the index, therefore, is that the stocks that are already a large part of the market continue to perform better. In our fictional example, strong performance of Company A, accounting for 66% of the index, leads to a better return than equally strong performance from Company B, which accounts for 33% of the index. This explains why ETFs and index funds tracking the US market have continued to perform so well.

The risk of buying what’s already gone up

However, there is a clear risk with this: eventually the stocks that have gone up, and seen their weighting increase, stop performing so well. By being weighted towards stocks that have already seen strong share price rises, such indices potentially have greater weighting towards higher-priced stocks and lower weighting to stocks that are cheaper and potentially underpriced.

This is the main downside of the market-cap weighted index. It results in investors tracking the index to invest more of their money in the frothiest, most bid-up parts of the market. As a result, some critics describe market-cap weighted indices as backward-looking, with the index requiring investors to own more of what has already gone up in the hope that it will go up further.

If the market has overestimated the prospects of certain stocks, as it has in the past, this can result in painful losses for investors. A notable example of this is the 1990s tech bubble, in which tech companies reached around 33% of the index. At the time, the company Cisco Systems became the largest company in the world with a market cap of $600 billion, accounting for 4% of the entire index at its peak. Any investor in an index fund or ETF at the time would have had to have the same exposure and, therefore, experienced a lot of pain when the bubble burst.

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Of course, there are several rebuttals to this concern from defenders of market-cap weighted indices. First, had investors in an index fund or ETF stayed invested and perhaps continued to invest at regular intervals (pound cost averaging), they would have eventually seen their portfolio re-enter positive territory. Similarly, a portfolio of several ETFs tracking different asset classes and indices would have protected against this bubble in the US market.

Jack Bogle, the founder of Vanguard, also identified the backward-looking nature of the market-cap weighted portfolio. The problem, he noted, is that there is probably no solution to this. The market may not always be efficient at pricing shares, resulting in periods of poor performance for market-cap indices – but no other method appears to be consistently much better.

That, however, has not stopped investors trying to get around the potential problem with market-cap indices. Aside from active management, one popular way is to use an equally-weighted index. This means that each member of the index accounts for the same percentage. So, in an index of 100 stocks, each would receive a 1% weighting. Several index providers offer these. For example, the Xtrackers S&P 500 Equal Weight ETF (LSE:XDEW) for the US or the VanEck Global Equal Weight ETF (LSE:TGGB) for global stocks.

There are, however, several major disadvantages of these ETFs. First, fees are somewhat higher compared to the cheaper market-cap versions of the indices they track. On top of that, they can incur higher rebalancing costs in their attempt to keep their equal weight.

Perhaps the biggest potential downside, however, is that the tech bull market continues for some time yet, leaving equal-weighted investors in the dust. With the economic conditions that make tech stocks so valuable over the past decade (slow economic growth, low inflation and low interest rates) seemingly not going anywhere any time soon, many doubt the outperformance of tech will end soon. In such a scenario, being in an equal-weighted ETF could result in serious underperformance. While eventually tech stocks will have to start underperforming, the past decade has not treated those who have tried to predict their demise kindly.

 

 

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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