ProfitScore Update – July 2023
To the clients and friends of ProfitScore:
One of the most fundamental and important parts of investing is achieving diversification through low or negative correlation. With the stratospheric rise in passive index investing, diversification is becoming harder and harder to find. Below is a chart from Bloomberg showing the co-movement of the S&P going back to 1928.
With increased correlation, money managers are increasingly looking for diversification through alternatives. Here’s how passive indexing might increase stock correlations:
Uniform Buying and Selling: When funds flow into or out of index funds and ETFs (exchange-traded funds), the securities within that index are bought or sold in tandem, regardless of their fundamentals. As more capital is allocated to passive strategies, these synchronized moves can lead to stocks moving more in unison.
Overemphasis on Large Caps: Many popular indices, such as the S&P 500, are market-capitalization-weighted. This means larger companies make up a more significant proportion of the index. When large sums of money are directed towards such indices, the largest companies experience the highest volumes of buying or selling. These movements in the largest companies can influence the broader market, increasing overall correlations.
Reduction in Active Price Discovery: As passive investing grows in popularity, there’s a reduction in the capital allocated to active strategies, which involve individual stock selection based on fundamentals. Active managers contribute to price discovery, helping to ensure that stock prices reflect their underlying values. Without as many active managers conducting thorough analyses and making individualized buy or sell decisions, stock prices are more likely to move in tandem, driven by broader market sentiments rather than company-specific news.
Feedback Loops: When certain stocks or sectors experience growth, they can become a larger portion of indices. As passive funds continue to buy these indices, more capital is allocated to these outperforming stocks or sectors, potentially pushing their prices even higher. Conversely, if an index starts to drop and investors begin to pull money out of passive funds, the sales can drive prices lower. This feedback mechanism can increase co-movements among stocks within an index.
Herding Behavior: The rise of passive investing may accentuate herding behavior during market turbulence. If market participants broadly believe that most other investors will sell (or buy) in response to certain news or events, individual stocks within popular indices might experience simultaneous sell-offs (or rallies), increasing correlations.
Decreased Differentiation: As more money flows into index funds, the incentive for deep, company-specific research might decrease. Without differentiated views on companies, stock movements become more about overall market sentiment and less about individual company performance, thus raising correlations.
It’s important to note, however, that while passive investing may contribute to increased stock correlations, especially in the short term, it’s not the sole factor. Globalization, interconnected financial systems, monetary policies, and other macroeconomic factors also play significant roles in influencing stock correlations.
Important disclosure information: Past performance of a ProfitScore index is not an indication of future results. You cannot invest directly in any ProfitScore index. The performance of any ProfitScore index does not represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in an index. A decision to invest in any such fund or portfolio should not be made in reliance on any of the statements discussed above. Inclusion of a security within any ProfitScore index is not a recommendation by ProfitScore to buy, sell, or hold such security, nor is it considered to be investment advice. Index performance does not reflect any management fees, transaction costs, or other expenses that would be incurred by a portfolio or fund, or brokerage commissions on transactions in fund shares. Such fees, expenses, and commissions would reduce returns. ProfitScore receives compensation in connection with licensing rights to its indices. All information relating to any ProfitScore index is impersonal and not tailored to the specific financial circumstances of any person, entity, or group of persons.