A $5 trillion market is at tipping point, could redefine stock trading

Reuters / John Gress

• For years, a public battle has been fought over the
  rise of indexing. Some say it helps efficiency and makes it
  easier to play the market, while others think it creates
  distortions.
• A new study from Vincent Deluard of INTL FCStone
  challenges the traditional idea that heavily indexed stocks are
  best suited to outperform the market.
• He says indexing has reached a “tipping point,” and
  lays out arguments for why that could change stock trading as
  we currently know it.

For years now, a debate has raged in the investment world over
the rise of indexing.

Its defenders will tell you it’s helped the efficiency and
diversity of the stock market, since traders have been
afforded endless opportunities to buy large swaths of stocks in
one fell swoop.

Its opponents have ardently stressed that indexing actually makes
the market less efficient. The argument there
is that single stocks contained in indexes stop trading on
individual fundamentals, and are instead dragged along with the
herd in price-insensitive fashion.

While this is an acceptable outcome when the market is climbing,
skeptics argue that it can worsen losses during times of weakness
— something many traders aren’t properly braced for when they
make a simple index investment.

Broadly speaking, the biggest lightning rod when it comes to
indexing is the ever-growing universe of exchange-traded funds
(ETFs), which are the most popular and
commonly used vessels for index investing. Having now swelled to
more than $5 trillion in global value,
the ETF complex is a behemoth that’s frequently blamed for market
distortions.

INTL FCStone macro strategist Vincent Deluard
fits firmly into the skeptics’ camp. He says it’s undeniable that
indexing — and, by extension, ETF use — has negatively impacted
market efficiency.

But he’s not exactly complaining. In his mind, understanding how
exactly indexing warps markets can be valuable in formulating a
strategy.

The only thing is, this strategy is about to get a huge overhaul,
because indexing is at what he calls a “tipping point” — one that
could alter the way people make money investing in stocks.

At the core of this assessment is the idea that as a stock gets
increasingly popular with index providers, it gets more
expensive. It’s something that hasn’t mattered much up to this
point, as investors have had no problem continuing piling into
these same inflated positions.

But based on recent data, the tide is starting to turn, says
Deluard. He points out that these “index darlings” are getting to
a point where they’re too overvalued, and will start generating
“disappointing” forward returns. When that happens, the unloved
companies mostly shunned by indexes will pick up the slack.

And that’s exactly what’s happened. As you can see in the chart
below, US stocks featured in less than 75 indexes have returned
65% over the past year — and returns have largely declined as the
threshold for index exposure have increased.

This is a far cry from the prior five years, which saw the exact
opposite dynamic unfold, with stocks more heavily represented in
indexes outperforming.

INTL
FCStone

So what can you do with this information? Deluard recommends
seeking out the “index ugly ducklings” that have been on such a
tear lately.

It’s a unique variation of the so-called value trade, where
investors look to scoop up discounted shares of companies that
are cheap relative to the market. Except in this case, he’s
suggesting traders seek out equities that are underrepresented in
indexes and the ETFs designed to track them.

“US equities have reached the ‘passive tipping point,'” Deluard
wrote in a recent client note. “Being popular with index
providers no longer yields excess returns. On the other hand, the
stocks that are under-owned by the index crowd may be priced to
deliver a higher risk premium over the long-term.”