QQQE - Passive Investing Is More 'Active' Than Meets The Eye
2023-07-28 03:30:00 ET
Summary
- Index providers make ongoing decisions to accommodate massive asset flows into passive vehicles. Case in point: the recent reshuffling of the Nasdaq 100.
- The purpose of the reshuffling was to maintain diversification and alleviate top-heaviness within the index.
- This can happen when individual companies representing more than 4.5% of the index soar high enough to account for more than 48% as a group.
By Doug Kramer
Index providers make ongoing decisions to accommodate massive asset flows into passive vehicles. Case in point: the recent reshuffling of the Nasdaq 100.
On July 24, the Nasdaq 100 index underwent a "special rebalance" to counteract rising overconcentration among a handful of tech giants - yet another reminder, in our view, that it pays to study the fine print on so-called passive investing.
The purpose of the reshuffling was to maintain diversification and alleviate top-heaviness within the index. This can happen when individual companies representing more than 4.5% of the index soar high enough to account for more than 48% as a group.
Given big tech's vaulting valuations amid giddiness over AI, the so-called "magnificent 7"-Apple ( AAPL ), Microsoft ( MSFT ), Amazon ( AMZN ), Alphabet ( GOOG ) ( GOOGL ), Nvidia ( NVDA ), Tesla ( TSLA ) and Facebook ( META ) - together accounted for 54% of the Nasdaq 100.
In the rebalance, the total was capped at 40%; that meant portfolio managers had to boost their smaller-cap positions to stay in lock-step with the index, while heavyweight names took temporary haircuts.
In our view, the Nasdaq's latest maneuvers demonstrate that indexation is a more "active" enterprise than meets the eye. Why not reduce to, say, 35% or 37.5%? We believe that level is subjective, and therefore one of the many active decisions index providers make.
Over the decades, equity indexes have morphed from simple benchmarks into thousands of low-cost investible products - thereby allowing investors to assemble well-diversified portfolios at low cost.
While indexing began as a way to buy an entire market, we believe index providers have adjusted their methodologies to maximize liquidity to help index fund managers - their primary customers - handle trillions of assets and build attractively scalable businesses.
We also believe those "active" decisions by index providers can translate into subtle opportunity costs for investors. These decisions include defining which shares qualify as part of the "free float" on which an index is based, as well as selecting which companies are ultimately included in an index.
While these adjustments can enhance liquidity, we believe they introduce opportunity costs that, by our estimates, could add up to roughly 35 bps a year.
We also believe a greater tilt into index territory could invite long-term structural threats as market-capitalization-based index vehicles robotically buy larger baskets of securities without regard for the prices of the individual constituents.
While this automatic approach keeps asset management fees low, we believe it ultimately thwarts the fundamental price discovery mechanism on which properly functioning markets are based.
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Passive Investing Is More 'Active' Than Meets The Eye