Watch out for the fangs! The risks of passive investment

Most investors – in fact, most people – instinctively understand the dominance of the FAANG stocks: Facebook, Apple, Amazon, Netflix and Google. They’re household names and they’re worth a lot. In fact, their joint market capitalisation is worth more than the entire equity market of the UK or Japan. COVID-19 hasn’t done these behemoths any damage either – staying home and streaming has only increased their value as they’ve helped us stay connected, entertained and sane. So what is the problem with those jaggy FAANGs?

Too big to fail?

It’s about disruption. Disruption of business models is part of life – it’s how organisations innovate and grow. Today, disruption is likely to occur in three ways:

1. Another company offers better products and services, winning then dominating market share. This is what happened to Nokia.
2. There’s a shift in supply or demand and products become obsolete: see Kodak and Blockbuster.
3. Poor environmental, social or governance impacts future earnings and market or regulatory forces punish the organisation. This could be around labour conditions, data breaches, tax policies, environmental issues or just plain bad PR: see Volkswagen or the good old Ratner effect.

If clients hold a passive US market cap equity tracker fund, their holdings are determined proportionately in order of company size. So, whether they realise it or not, they have a disproportionate amount of investment in a very small number of companies. Are your clients confident these huge organisations can deal with disruption when the time comes? (And it will come.)

Make your own index

We believe risk control should always be considered as part of the index composition in passive funds. Market cap indices may come cheap, but they don’t easily help you manage stock or sector concentration. It’s better to create a trackable index using a set of different rules – one that rewards companies with a higher weighting only if they satisfy your criteria, rather than because they just happen to be large.

Your criteria could include:

• value (stocks that appear cheap)
• low volatility
• quality (high-quality companies)
• size (smaller companies).

Clients may also have their own factors in mind, like increasing exposure to companies with good environmental practices, or avoiding specific industries like alcohol or tobacco.

We believe it’s always worth looking at a mix of market cap and factor-based equity to provide efficient fees, good diversification and access to regions and criteria that will hopefully work together to add value over the long term. That’s not to say we’re expecting the world to stop Netflix and chilling any time soon. It’s rather that portfolio diversity, as always, should still be at the top of every Financial Advisor’s watchlist.