Han Dieperink: The index that beats the index

Han Dieperink: The index that beats the index

Asset Allocation
Han Dieperink

By Han Dieperink, written in a personal capacity

Index investing has grown strongly this century. Passive investing in the index is now even greater than active investing. This makes it by far the largest investment strategy ever.

Passive investing is, as it were, a 'self-fulfilling prophecy'. The prediction is that index investing is better than active investing and when you act on this prediction, it actually comes true. When it is predicted that the value of a company on the stock exchange will increase, there will be more demand for that company's shares and therefore the value of that company will increase. The same happens with the index. However, there are some unexpected consequences.

Index investing is not that passive at all

Every year, asset managers are compared with each other and what is striking is that providers of index investments show even greater differences amongst themselves than active asset managers. In practice, passive index investing is not that passive at all. This is because there are often large differences between the indices. For example, there are large differences in regional distributions, or as a result of the choice whether or not to hedge currency risk, exclude certain markets, weight equally instead of market capitalization, or, for example, weight based on GDP.

The decision to have a European home bias of 50% may also have had quite an impact in recent decades. The correction for the free float can also have a major impact and for some time now there have also been many sustainable variants of indices with a different weighting and a different performance.

These are all very active choices, with even greater deviations than active asset managers. These normally accept a much lower tracking error compared to the index. Actually, the active asset managers are much more passive and the passive asset managers are quite active. Of course there are differences in costs, but these active choices have an impact equal to a multiple of the costs. Ultimately, what matters is the net return.

Heaviest stocks are becoming heavier and heavier

In an index, the most money usually goes to the stock with the heaviest weight in the index. That money ensures a higher valuation and therefore an even higher weight in the index. Shares that are not in the index do not receive any money. Nowadays there are relatively many companies that are owned by a holding company. The company is part of the index, the holding company usually is not.

Take the Heineken share, for example. The most important and majority shareholder is Heineken Holding. The shareholder of the holding company has more rights than the ordinary shareholder, but nevertheless the discount for the holding company has increased to 15 euros. Explanations that are often given are the less liquidity of the Heineken Holding share or the fact that derivatives are only issued on the Heineken share. But more money also flows to Heineken because it is included in important indices and that contributes to the discount for Heineken Holding. The largest discounts in holding companies can be found in South Korea.

Everything goes to the top 1%

Because not every index investor uses the same index, most of the money goes to stocks that appear in each index. In practice, this is the top 1% of all shares. Big Tech companies in particular are included in many indices, also because they score high in the field of sustainability thanks to the presence of a Chief Sustainability Officer. Many Big Tech companies are also used for various thematic indices. Apparently they are versatile companies. A portfolio with index investments may be optically well diversified, but therefore underlyingly very concentrated in Big Tech.

The result is that, just like in society, more and more wealth goes to the top 1%. They use the higher valuation to strengthen their position, for example by acquiring promising starters at an early stage. It is now clear that these top 1% largest companies have done much better profitably than the rest of the stock market in recent years.

Now there is also an index containing the top 1% of all shares. That is the Dow Jones Global Titans index. Naturally, the Magnificent Seven are well represented. Due to their size, the companies in this index can easily attract staff, pass on higher costs and finance themselves cheaply. They also benefit above average from government support and due to their net liquidity position they do not bear the burden of higher interest rates. For these companies, a higher interest rate actually means more income.

Of course, there are always the traditional economies of scale and network effects. And in the case of artificial intelligence, there is no law of diminishing returns. Bigger is always better.

Small shares are in danger of disappearing

As the weight of the large stocks in the index increases, fewer and fewer stocks will be included in the index. The smallest shares in the index are then in danger of disappearing. Perhaps the underperformance of the small caps is partly due to this. Since 1996, 40% of listed companies in the United States have disappeared.

Normally, index investing reflects stocks that have already done well, but in this way it is more of a momentum strategy in which the stocks with the heaviest weight are ultimately the winners. This means that passive investors do not have to look at complicated matters such as profit and return on invested capital. Simply the weight in the index is sufficient. This Global Titans index is 11.3% higher this year compared to 5.8% for the 'broad' world index. The index beats with an index.