Exchange Traded Funds And The Market-Cap Weighted Cliff

Includes: HSBC, NSRGY
by: Lipper Alpha Insight

By Jake Moeller

The first quarter of 2017 was a very good one overall for the pan-European funds market. Thomson Reuters Lipper data reveals nearly €170 billion of estimated net sales for the period for active, tracker and exchange traded funds (ETFs) combined.

This is 70% of total net sales for the whole of 2016 and suggests that in the absence of any market catastrophe, the industry could be on target for a record year of sales.

Exhibit 1. Pan European Mutual Fund Estimated Net Flows

Source: Thomson Reuters Lipper

The first quarter of 2017 also revealed that investors' affection for passive investments remains strong with total estimated net sales for passive vehicles constituting 20% of all sales. Indeed, more recently in April 2017, six of the top ten best-selling funds were passive funds.

Passive funds and share registries

The popularity of passive investments can also be seen in the share registries of large cap companies around the globe. Looking at the most recent fund shareholders report for the FTSE 100's largest constituent - HSBC Plc (NYSE:HSBC), only four of the top 20 fund holders of the stock are traditional active fund managers with the other fund holders consisting of trackers/ ETFs (13 holders) or large pension funds ( 3 holders).

A similar picture is revealed for the U.S. market. For the S&P 500's largest stock - Apple, tracker funds/ ETFs constitute 13 out of the top 20 fund holdings with 5 individual Vanguard trackers amongst those.

Exhibit 2. Fund Ownership Summary of HSBC

Source: Thomson Reuters Eikon

In Europe, the FTSE Europe ex UK's largest stock Nestlé (OTCPK:NSRGY), also has concentrated fund holdings in passive vehicles but less so than the markets above. 12 of the top 20 largest holdings are either passive/ ETF or large pension funds.

It takes a professional stock analyst to say whether or not Apple (NASDAQ:AAPL) at a PE of 18, Nestlé at 30 or HSBC at 320 represent good value for money or not but even for these highly liquid stocks, given the ongoing growth in passive investing, at some point, there is going to be a surfeit of investors buying large cap stocks at any price. These may not possibly be the most prudent purchases as we enter the later stages of the economic cycle.

How to avoid the passive herd?

Active funds are a solution for those who are in anyway concerned about market herding and certainly one that I would strongly advocate. However, even for the most diehard passive investors there are an increasing range of solutions. The rise of "smart beta", factor and multi-factor investing has really taken hold in Europe. At the end of 2011, there were 27 factor-based ETFs with a comparatively paltry €248 million of assets under management. At the end of April 2017, there are over 260 smart beta products containing some €1.7 billion of assets.

The concept of "diversifying" beta exposure has been a staple of institutional investors for many years. Given the rising tide of asset flows and the increasing share of this into passive products, this should be something that retail passive investors become familiar with lest like lemmings they run over the market cap weighted cliff.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.