6th September 2024
Earlier this week we came across two excellent academic studies when reading the brilliant Joachim Klement blog (Klement on Investing). Now I know writing the words ‘academic’ and ‘study’ next to each other is a sure-fire way to send most readers to sleep – but it is hard to overstate the importance of this work so please bear with me!
The first study by Hao Jiang, Lu Zheng and Dimitri Vayanos focuses on how passive investing affects asset prices with some important conclusions:
- Flows into passive funds disproportionately raise the prices of the stock market’s largest firms, and especially those large firms that the market overvalues.
- These effects are sufficiently strong to cause the aggregate market to rise even when flows are entirely due to investors switching from active to passive.
- Passive investing biases the stock market towards overvaluation.
Wow.
The third point is one we have observed in large, liquid markets for several years, very specifically in the US. The US equity market on a range of valuation measures (price-to-earnings, price-to-dividend-yield, cyclically adjusted price-to-earnings, market-cap-to-gross-value-added) is trading at or very close to the most expensive levels in the last 75 years. And it has consistently traded above long-term averages for these multiples for the past 15-20 years, coinciding with the boom in passive investment.
One of the key reasons for this is the concept of elasticity of demand. For those that haven’t studied economics, elasticity of demand refers to how much demand for a product (in this case a stock) changes when the price of that product changes. Inelastic products see little change in demand in reaction to price changes, highly elastic products see big changes in demand when there are price changes.
A follow-on research paper by Valentin Haddad, Paul Hubner, and Erik Loualiche showed that large cap stocks are far more inelastic than small cap stocks. There are several reasons for this, but intuitive ones include the weight of money forced to own large cap stocks for liquidity purposes, as well as the prevalence of career risk which encourages an unfortunately large cohort of so-called active managers into index hugging behaviour and ownership of larger benchmark constituents to mitigate job threatening levels of underperformance. Overall, no matter what happens to the prices of these stocks, there is a huge constituent of holders, and relatively few willing sellers. This means that additional demand for large cap stocks creates outsized moves higher in the stock prices, and thus forces the valuation of these stocks higher relative to small cap stocks.
When you compound this phenomenon over many years (into decades), it creates the conditions we have now reached – namely incredibly rich valuations for the largest, most liquid stock markets. But also, massive valuation dispersion, and exciting opportunities if you look beyond areas of markets that have become increasingly dominated by passive investment.
It is one of the big reasons why we can consistently find portfolios of stocks in Asia, Japan, the UK and Europe (and even in the US outside of the S&P 500) that are incredibly attractively valued (in absolute and relative terms), offering high dividends and good growth prospects.
This elasticity of demand point works two ways, however. When stock prices are rising, and money is flowing into passive solutions, it disproportionately drives stock prices (and valuations) even higher. However, when flows turn, it will result in outsized price moves to the downside too. We have seen examples of this during the sharp covid drawdown and the recent sharp drawdowns in major indices in early August. It increases the instability of large cap equities (especially in the US which have been prime beneficiaries of passive flows) and increases their risk both in terms of volatility profile, but also in terms of the risk of permanent destruction of capital given very elevated starting valuations.
We hope and expect that the Funds’ relatively low exposure to US large cap equities (Vanbrugh has zero exposure to the Mag 7 for example) mitigates this downside risk, whilst the great opportunities we are finding by digging below the surface lay the foundation for good medium to long term absolute returns for our Funds.
Dan Cartridge – Fund Manager
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