I like to consider myself relatively fearless. Sharks and snakes aside, a little market volatility never hurt anyone, nor do the headlines that periodically declare the end of capitalism as we know it.
I’m also a ‘passive’ investor by temperament. A few broad-based index funds, a modest satellite allocation here and there. It’s the approach I settled on after a few years of underperforming the market by picking individual companies.
A few months ago, I was sitting at an investment convention, as engaged as one can be after a long day of conference-hall haze. The panelists were deep in discussion on Australian equities while I was nursing a lukewarm coffee. Then one speaker said something that snapped me out of my stupor.
Almost a third of the ASX is a cyclical bet on Chinese demand and our second biggest company is an exploit of intergenerational inequity, acting as the intermediary between those who have capital and those who need it.
It was the kind of observation that everyone is vaguely, almost unconsciously aware of, yet we rarely hear articulated so plainly. Of course, we know not to take these words as gospel (and I have my own reservations about the recent enthusiasm for the term ‘intergenerational inequity’), but I can appreciate the blunt framing.
Many passive investors like to imagine we’ve opted out of stock-picking, that we’ve somehow been absolved of that responsibility. But every index represents a set of active decisions about which risks to accept, which sectors to overweight and ultimately, which narratives to believe.
A growing tension
Concerns about the increasing concentration of the ASX are not new, however the current dynamics reveal a more notable conflict. On one side, several hedge funds are positioning against the major banks citing a mix of macro weakness, stalling property prices and declining credit growth. On the other hand, passive flows have been driving capital into the largest, most richly valued companies, essentially reinforcing the dominance of the same names. The market has effectively split.
Over the past decade, Australia’s market valuation has expanded meaningfully, yet earnings growth has been modest. The US has delivered robust growth driven by technology and productivity gains. By contrast, the ASX has leaned heavily on commodity cycles and the near-mythic stability of residential mortgages.
Performance of the Ten Largest ASX Companies in 2016, Annual Returns and Net Income Growth Over the Past Decade.
Source: Australian shares are falling behind the world.
Theoretically, when key drivers of economic growth such as housing begin to slow, earnings should eventually slow with them. Yet we haven't seen prices adjust in the same way. I think we’re well past the point where passive investing can be described as merely reflecting the market. There is a credible argument that it now shapes the market. Even the idea that ‘the market’ is a neutral arbiter of value, becomes less convincing when a large portion of flows are valuation-agnostic.
For some investors, this dislocation represents an immovable object. Perhaps a structural feature of modern markets that must simply be accepted. For others, the widening gap between fundamentals and index-driven pricing may present opportunity.
Where to from here?
For many investors, the ASX has been a faithful companion for decades. The banks, miners and the industrials that dominate the index have delivered income, stability and a sense of familiarity. But the country is shifting. The slow reshaping of Australia’s economic foundations has forced many to lift their gaze.
What is harder to ignore is the growing influence of passive flows in setting the prices of the heavy-weights. When money pours into index funds irrespective of valuation, fundamentals inevitably appear to play a smaller role. As a 'passive' investor myself, I find this dynamic increasingly difficult to dismiss.
Simonelle Mody
Also in this week's edition...
Treasury has confirmed the tax exemption for discretionary testamentary trusts. Rachael Rofe explores two conditions that could still leave some wills on the wrong side of the exemption.
David Tuckwell from ETFShares examines how ASX investors should think about the long-term case for lithium after its recent sell off.
Ethan Xing from Zenith models how fund turnover could become a key driver of after-tax returns under the proposed CGT reforms.
Superannuation was built around assumptions that no longer hold. Adam Nettheim discusses the key challenges he believes policymakers and super funds need to address.
Retirement looks different for everyone. Dr Joanne Earl shares an update four months into her journey.
Australian investors have rarely been asked to navigate so much at once. Arian Neiron from VanEck argues that the Federal Budget has exposed why quality investing needs a rethink in Australia.
The economics behind AI spending look increasingly questionable. Harris Kupperman from Praetorian Capital explains why he thinks today's AI boom has striking parallels with the shale bust.
Curated by Simonelle Mody and Leisa Bell
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