Investors may be surprised at just how much price risk is embedded in today’s benchmark indices.
By Simon Hallett, CFA, Co-Chief Investment Officer, Harding Loevner
A couple of months ago, Exxon was summarily dropped from the Dow Jones Industrial Index, after having been included in the index since its inception 92 years ago, to be replaced by software giant salesforce.com. Exxon’s deletion, in itself, was not a big deal for investors. Despite its iconic place in the investor psyche, the Dow is not a great proxy for the broad U.S. stock market or widely used as a benchmark for investing.
But that a company once as dominant as Exxon could see its stock price and market capitalization fall to the point where it was no longer considered large enough or important enough to be worth including does make me think a little about the price risk embedded in some of today’s most dominant companies. It also highlights the arbitrary role indexes play in an era when so many U.S. savings are directed at passive equity strategies.
The Cautionary Tale of Japan, Inc.
Most people assume that when they invest in a passive fund that they can sidestep any active investment decision making. But there are three problems with this assumption. One is that, even if there is no individual stock selection going on, choosing a benchmark is by definition an active decision, and one that can matter a great deal. For example, investing in bonds using the Bloomberg Barclays U.S. Aggregate Bond Index versus the ICE BofA U.S. Corporate Index will result in different exposures to both interest and credit risk.
A second issue is that the indices themselves are not passive—someone must decide that it is time for Exxon to leave, and salesforce.com to enter. This is true whether the benchmark is the idiosyncratic Dow, the more representative S&P 500, or the still-broader MSCI Index of global equities.
The third, and perhaps most consequential, problem relates to the most common index construction methodology. Most indexes are, capitalization-weighted, meaning that the indexes are dominated by securities that have done well in the recent past. If past performance were a guide to future performance, that could be a helpful characteristic. But, as we all know, in fact the opposite is usually the case.
This focus on yesterday’s winners becomes particularly problematic when past performance is concentrated in a small number of constituents or market segments.
A great example of this kind of skew is the EAFE index in the 1980s. (The MSCI EAFE (Europe, Australasia and Far East) Index measures the stock market performance in developed economies outside the United States and Canada.) In the mid-1980s, a strengthening yen and loose Japanese monetary policy stimulated a tremendous runup in Japanese stocks. By the late ’80s, stocks of many run-of-the-mill Japanese companies were trading at close to 100 times annual earnings, and stocks of Japanese banks (whose returns on equity were much worse than run-of-the-mill) were trading at high multiples of their book value. Ultimately, Japanese companies came to make up roughly two-thirds of the EAFE index, with Japanese banks alone accounting for a significant percentage of the index.
The consensus opinion of the day argued that these prices were justified by the combination of low Japanese interest rates and the prospects for earnings growth – growth that many believed would extend far into the future as the Japanese social and corporate miracle came to dominate global economic activity. Spoiler alert: That proved to be mere narrative, not an accurate forecast.
The bubble burst in 1989: returns to the EAFE index were dismal, and the Japanese market has still not recovered thirty years hence.
Passive investing was less common in the 1980s than it is now, but any active manager who avoided the Japanese market in the 1990s outperformed their benchmark and passive counterparts.
Unfuzzing the Math
Today, there is a similar consensus about a relative handful of giant technology-related companies that have come to dominate their industries. In many cases, these companies have been superbly run and have delivered great benefit to their customers. The advent of COVID-19 has further boosted their prospects, by accelerating the migration of commercial activity online.
There may seem no reason why the current state of affairs wouldn’t continue. One could take this a step further and make the argument that the high prices of these companies, as measured by simplistic price-to-earnings ratios, are justified. They have already shown that cash flows can grow at a high rate for many years. And given that the interest rate we use to discount those cash flows to present value today is close to 0%, why shouldn’t their prices be high?
History has shown that the largest companies at the start of any 10-year period are rarely the largest at the end. Even the most rigorous estimates of value are rife with uncertainty. Even if we assume that the competitive structure of these companies’ industries remains favorable, their technologies remain leading ones, their management continues to execute well, and cash flows continue to grow 20% or more for the next 20 years, can we really say with much certainty what interest rates will be in two decades’ time?
Let’s assume for a moment that we were to use a reasonable, but higher, estimate of tomorrow’s interest rates to estimate the current price paid for companies’ future cash flows. Hold all the other rosy estimates for sales growth and profits the same.
What would happen if instead of 0% interest rates forever, we assume that they creep back up to 2% at the end of ten years? -The math of the present value calculation suggests that their stock prices would drop by about 60%.
Of course, most investors in passive strategies are not performing such calculations. Most invest in market index funds and ETFs simply because they believe it is preferable and less risky to “own the market” rather than trying (and failing) to predict which active manager will outperform it.
But passive investing is not risk-free. At the very least, index fund investors continue to bear market risk – the same risk that active investors bear.
At the same time, passive investors should pay more attention to the price risk embedded in the small number of companies that increasingly determine a large portion of their returns. Those companies’ outsized market capitalizations rest on assumptions about future growth and future interest rates that are hard to defend. Trying to match the market by owning proportional shares in all of today’s massively weighted digital winners increases the chance of owning tomorrow’s Exxon or Japanese bank.
Today, investors are attracted to markets by returns, but those returns have been dominated by the stocks of small number of companies with very large market capitalizations. Investors in passive products aren’t paying enough attention to embedded price risk.
Summing It Up
Many investors see a clear distinction between index investing and active management, but the reality is much more complicated.
Index investing involves active decision making – on the part of investors when they choose an index fund for their portfolios and on the part of index constructors when they make decisions about index composition.
Both index investing and active investing involve risks, such as market risk. In addition, because of their method of construction, most index funds have the risk of overexposure to strong past performers. In fact, investors may be surprised at just how much price risk is embedded in today’s benchmark indices.
Indeed, investors should be sure to understand the risks in all their portfolio investments, including passive fund investments.
To conduct our back-of-the envelope analysis, we made a set of now-standard assumptions employed in many of today’s discounted cash flow models. We assumed that the cash flows of our average fast-growing technology giant would grow at 20% a year for 20 years before leveling off to a terminal rate of 2%. We also assumed a standard equity risk premium of 4%, which together with the estimated risk-free interest rate determined the discount rate we used to discount cash flows back to their present value. The risk-free interest rate, as stated, was assumed to be 0% for 10 years before rising to 2% after that.