Is Passive Feeding The FAANGed Mega-Cap Beast?

This leads us to our third point: The one possibility that could make selloffs worse is if institutional and retail investors were more likely to panic and sell if they hold passive funds.

However, there has been some evidence that investors in passive index mutual funds are less likely to sell.3 And the BIS Quarterly Review reported that investors in index mutual funds have acted as a “stabilizing influence” in times of market stress while acknowledging ETF flows were more volatile.4

Passive and mega-caps

Now we can address if passive investing has helped drive the mega-cap outperformance and if a bubble can be identified.

We start by looking at the valuation of companies across the market cap spectrum by using sales to market value as a simple gauge of the fundamental value of a company. This metric is not susceptible to accounting manipulations and can give us a rough gauge of valuation changes over time. We focus on the following U.S. indices: S&P 500®, Russell 1000®, Russell 1000® less S&P 500 as mid-cap proxy, Russell 2000®, top 50 stocks by market cap, and top 10 stocks by market cap relative to the Russell 3000® Index, which covers approximately 98% of the U.S. market capitalization.

(Click on image to enlarge)

Index sales

Source: Russell Investments, S&P, FTSE Russell

From observing the trends, it is possible that there could be a relative mega-cap bubble based on this simple valuation metric. Since 2015, the percentage of the U.S. equity market attributable to the top 10 stocks has increased significantly, as the performance difference between the largest and smallest stocks has significantly widened (see charts below).

(Click on image to enlarge)

Weight of sub indices relative to Russell

Source: Russell Investments, S&P, FTSE Russell

Cumulative quarterly excess
Source: Russell Investments, S&P, FTSE Russell

While it is possible there could be a bubble in the mega-cap names, based on what we have established as the mechanisms of passive investing:

  1. Passive investing has not created the mega-cap bubble.
  2. It is possible that passive investing could make a mega-cap bubble harder to correct by active investors.
  3. If there is a bubble and the market cap valuations converge, passive investors will not only participate in 100% of the upside but also 100% of the downside.

This implies that now could be a better time than ever to employ active management with a long-term valuation discipline.

The bottom line

View single page >> |

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and ...

more
How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.
Comments have been disabled on this post.