Former Chairman, China Banking Regulatory Commission
Like many of you, I used to be a traditional banker who was “properly” trained to look for qualified projects to invest from two important dimensions.
One is top-down dimension. Simply put, that includes, but not limited to, the macro-policies, the macro-economic and social conditions, and the changes or possible changes of the three. The other is bottom-up dimension. Simply put, that includes, once again, but not limited to, the micro-stories of the target company or project, such as strategies, corporate governance, and the leadership, etc.
So it was taken for granted that we all followed these “Bibles”, which in turn opened the door to a world of opportunities.
Unfortunately, most of the people in the financial world are not so lucky. It turns out, maybe not surprisingly, that almost every 8 to 10 years after the Second World War, we witnessed economic and financial crisis, and many borrowers, together with their financiers, went bust. The reason is simple: in many parts of the world, information about those two dimensions is not readily accessible. And that information scarcity led to a crisis.
So to put that sadness in perspective, people created index. The rise of indexing over the past two decades has exerted profound influence on the global and regional equity and bond markets, as passive funds and ETFs, as well as professional managers and active fund managers benchmark their investment performance to the indices.
Indexing brings us convenient tools, which we use as the third dimension, which is a marvelously enticing dimension, but it’s kind of fraught. What might not be quite as obvious to people is that index is very procyclical. In plain English, in using index for investment, it depends on the tide change in the market: the better day, the more chances, but also: tree fallen, people with axes.
Taking equity markets for example. Every passive-funds and ETFs are benchmark against an index. For example, the rise of FAAMG makes the 5 stocks accounting for 23% of the S&P 500 index (495 stocks account for 77%), from under 15% just 5 years ago. As the FAAMG market cap increases, their weight in the S&P 500 index increase, which prompts investment managers to buy more of FAAMG stocks, which push up the stock price (and market cap), and thus the positive momentum.
On the flip side of the coin, the dramatic underperformance of MSCI China so far in 2021 (absolute of relative to Shanghai index or Shenzhen index) serve as a vivid reminder of down-cycle risks, as Baidu, Alibaba, Tencent, JD, Meituan and Xiaomi underperformed, and set off the reverse price momentum.
The fallacies work the same in the bond market. Investors in the China IG and HY bonds experienced the pain in 2021. As issuers issued more bonds (Evergrande, Huarong, …) their weighting in the index increases, thus funds and professional investors purchased more of these bonds. The debacle in 2021 has been particularly painful.
There has been much discussion recently about the rising risk embedded in the third dimension. How can we cope with the index fallacies? Honestly, there is not much ETF and passive manager can do but to benchmark and follow the indices and fallacies. That’s their job.
However, for professional managers and active fund managers, it is crucial that they understand the dynamics of ETFs and passive funds, and how indexing and its fallacies can positively or negatively influence the market (positive price momentum and reverse price momentum), and how to avoid concentration risks and significant portfolio losses.
Some funds have built-in diversification safety measures, such as each stock (or each bond issuers) shall be no more than 5% of entire portfolio. Anyway, it is inevitable that such diversification measures will handicap performance in a bull market, when comparing to index returns.
It’s hard not to love capital and the index, but please be reminded, diversification of investment, like friends, should be few and well chosen. So bind the sack before it be full. thank you!