(Sky) – The biggest development in investing during the last two decades or so has been the rise and rise of so-called “passive” investments – low-cost tracker funds that seek to replicate the performance of a particular stock index.
The theory runs that only a small proportion of so-called “active” fund managers will outperform their benchmark, such as a stock index, during a given period.
Why then, goes the argument, would an investor pay more for the services of an active fund manager when they could just leave their money in a low-cost tracker?
The FTSE 100 is down by 16% so far in 2020
Supporters of active investing point out that a passive strategy will not necessarily protect investors when the market is falling.
The FTSE 100 is down by 16% so far in 2020. Anyone who invested £1,000 in a Footsie tracker at the beginning of the year will have seen their investment – leaving aside the impact of dividends received – shrivel to £840. A good active manager would expect to beat that.
The flow of money, though, suggests investors are increasingly opting for the passive option. Globally, an estimated $12trillion is now invested in index funds.
In the UK, the latest statistics from the Investment Association, the industry body, reveal that, in September, its members notched up net retail sales worth £1.596bn, of which £1.262bn found its way into tracker funds.Why
Firstly, the Dow Jones Industrial Average – not the most meaningful stock index in the US, but certainly the best-known – is set to go above 30,000 for the first time.
Practically speaking, although there is very little difference between the Dow being at 29,999 and 30,000, investors love to grab hold of these big round numbers and construct a narrative around it. Investment advisers and pundits use these kind of index events as sales opportunities.
Among the most famous was the late Joe Granville, a popular investment writer in the US, who published a newsletter called the Granville Market Letter from 1963 until his death in 2013.
Credited with real market-moving power after accurate predictions in the 1970s and 1980s – he famously told his followers to “sell everything” in January 1981, shortly before a 20% fall in the Dow over the subsequent 15 months.
Mr Granville launched the “Dow 10,000 Club” in April 1997 and told his followers the Dow would hit 10,000 the following January and organised a cruise holiday around the event for devotees to celebrate.
Around the same time, car bumper stickers began appearing across America, bearing the legend “10K in 2K”. In the event, the index did not hit that benchmark until January 1999, but people loved – and bought – the idea.
Accordingly, when the Dow crosses 30,000, it is likely to spark more buying simply because a psychological barrier has been passed.
In truth, the Dow is a pretty meaningless barometer of American corporate health, since it only has 30 constituents and, crucially, it is weighted by share price rather than by stock market valuation.
Accordingly, the stocks which have the biggest impact on the Dow right now are not Apple, with a stock market valuation of $2trillion – Microsoft, which is valued at $1.64trillion, or even Visa, which is valued at $453billion.
The most influential stocks are currently United Health, which is valued at $339bn; Home Depot, which is valued at $301bn and Salesforce.com, which is valued at $227bn.
Those three stocks make up just under a fifth of the Dow on their own. By contrast, Apple accounts for just 2.64% of the Dow.
The more meaningful US stock indices are the Russell 2000, which tracks the fortunes of 2,000 American small-caps and the S&P 500, which tracks the fortunes of a larger basket of big American US companies than the Dow.
That is why the second upcoming event is so interesting.
After the closing bell on Monday night, S&P Dow Jones Indices announced that Tesla, the electric car maker, will be admitted to the S&P 500 on 21 December.
It had previously not been admitted, despite being one of the biggest quoted US companies, because, in order to qualify, a business needs to have reported net profits for four consecutive quarters. Tesla has just notched up its fifth.
The move however, is going to create a headache for many tracker funds. Tesla, whose shares surged by more than 12% on the news, is one of the biggest companies ever to be admitted to the S&P 500.
Its stock market valuation of $387bn means that, were it to be admitted today, it would immediately be the 10th largest company in the index.
Although, because 20% of its shares are owned by its founder Elon Musk, it will only have an 80% weighting. That would still make it the 15th largest company in the S&P 500, fitting in somewhere between Nvidia and Home Depot.
In other words, Tesla’s admission to the S&P is going to pose a challenge to passive fund managers tracking the S&P, not least as they try to work out what to sell as they build up their holdings in the company.
One possible victim could be Amazon. That is because the S&P is itself divided into 11 sectors which are also tracked by passive investors. Tesla will be admitted to the “consumer discretionary” sector of which, at present, Amazon accounts for 39.6%.
That will fall to 35.8% after Tesla joins the index. So it is possible some passive investors will sell Amazon shares in order to build up their weighting in Tesla.
Because of the sheer size of the shake-up, S&P Dow Jones – which has not yet said which existing S&P 500 member will make way for Tesla – is asking market participants how they think the company should enter the index, in particular whether they would like to see Tesla admitted in stages.
But make no mistake – this is going to be a big event.
Around a quarter of the S&P 500, which is worth $31.8trillion, is owned by passive funds. In other words, funds worth a total of $7.95trillion are going to be rejigging a significant portion of their portfolio as they try to work out how best to replicate the S&P 500’s performance once Tesla is a member.
Some analysts believe that, with so many funds shortly to become forced buyers of Tesla, it could be a good time to take profits in the stock after what has been a meteoric run.
Others may try to take advantage of a dip in Amazon’s share price if the passives are forced to cut their stake in that company.
But it is certainly a huge moment – and one that will have more “real world” consequences than the Dow going above another psychological barrier.