A $5 trillion market is at a tipping point that could redefine how investors make money trading stocks
Reuters / John Gress
- For years, a public battle has been fought over the rise of indexing. Some say it helps efficiency and makes it easier to play the market, while others think it creates distortions.
- A new study from Vincent Deluard of INTL FCStone challenges the traditional idea that heavily indexed stocks are best suited to outperform the market.
- He says indexing has reached a "tipping point," and lays out arguments for why that could change stock trading as we currently know it.
For years now, a debate has raged in the investment world over the rise of indexing.
Its defenders will tell you it's helped the efficiency and diversity of the stock market, since traders have been afforded endless opportunities to buy large swaths of stocks in one fell swoop.
Its opponents have ardently stressed that indexing actually makes the market less efficient. The argument there is that single stocks contained in indexes stop trading on individual fundamentals, and are instead dragged along with the herd in price-insensitive fashion.
While this is an acceptable outcome when the market is climbing, skeptics argue that it can worsen losses during times of weakness - something many traders aren't properly braced for when they make a simple index investment.
Broadly speaking, the biggest lightning rod when it comes to indexing is the ever-growing universe of exchange-traded funds (ETFs), which are the most popular and commonly used vessels for index investing. Having now swelled to more than $5 trillion in global value, the ETF complex is a behemoth that's frequently blamed for market distortions.
INTL FCStone macro strategist Vincent Deluard fits firmly into the skeptics' camp. He says it's undeniable that indexing - and, by extension, ETF use - has negatively impacted market efficiency.
But he's not exactly complaining. In his mind, understanding how exactly indexing warps markets can be valuable in formulating a strategy.
The only thing is, this strategy is about to get a huge overhaul, because indexing is at what he calls a "tipping point" - one that could alter the way people make money investing in stocks.
At the core of this assessment is the idea that as a stock gets increasingly popular with index providers, it gets more expensive. It's something that hasn't mattered much up to this point, as investors have had no problem continuing piling into these same inflated positions.
But based on recent data, the tide is starting to turn, says Deluard. He points out that these "index darlings" are getting to a point where they're too overvalued, and will start generating "disappointing" forward returns. When that happens, the unloved companies mostly shunned by indexes will pick up the slack.
And that's exactly what's happened. As you can see in the chart below, US stocks featured in less than 75 indexes have returned 65% over the past year - and returns have largely declined as the threshold for index exposure have increased.
This is a far cry from the prior five years, which saw the exact opposite dynamic unfold, with stocks more heavily represented in indexes outperforming.
So what can you do with this information? Deluard recommends seeking out the "index ugly ducklings" that have been on such a tear lately.
It's a unique variation of the so-called value trade, where investors look to scoop up discounted shares of companies that are cheap relative to the market. Except in this case, he's suggesting traders seek out equities that are underrepresented in indexes and the ETFs designed to track them.
"US equities have reached the 'passive tipping point,'" Deluard wrote in a recent client note. "Being popular with index providers no longer yields excess returns. On the other hand, the stocks that are under-owned by the index crowd may be priced to deliver a higher risk premium over the long-term."
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