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OPINION

The bigger they are...

The bigger they are...
December 3, 2020
The bigger they are...

I say so because this year has been terrible for the UK’s biggest stocks. Five of the six largest ones have fallen more than 20 per cent this year: GlaxoSmithKline, Royal Dutch Shell (both A and B shares) HSBC and BP. Together, these five alone account for more than half of the All-Share index’s 15 per cent drop this year.

 

 

You might think this vindicates a common argument against index trackers. This is that these are not as well-diversified as they should be because they have big holdings in a few stocks. At the start of this year, All-Share tracker funds had 50 times as much exposure to HSBC as to the typical FTSE 250 stock – and with HSBC falling 35 per cent, this was an expensive bet.

In fact, though, tracker funds haven’t done catastrophically badly this year. As I write, Scottish Widows’s All-Share tracker’s performance so far this year puts it 121st out of 241 funds in Trustnet’s all companies database. That’s firmly mid-table.  

There’s a simple reason for this. Yes, active managers might have underweighted HSBC and the oil majors earlier this year and so outperformed. But many also underweighted Reckitt Benckiser and Astrazeneca, two big stocks that have risen this year. Net, the upshot is that trackers have done about average this year.

And in the US, they’ve done better. L&G’s US index fund for example is 53rd out of 148 North American funds. This is because the S&P 500 has been pushed up by its biggest stocks such as Apple, Amazon and Microsoft and tracker funds, unlike most active managers, avoided being underweight in these.

Which poses the question. If active managers generally haven’t profited this year from underperformance by mega-caps, when will they do so?

Their best chance comes when most shares beat the market – that is, when the market is dragged down by big stocks. This happened last year. Over the long-run, though, it doesn’t happen. Although there have of course been spells of outperformance or underperformance by big stocks, there has been little long-run trend. Indeed, before this year the FTSE 100 had actually outperformed the small-cap index over the long-run, with a total return in the 30 years to December 2019 of 7.8 per cent against small caps’ 7.1 per cent.

In the long-run then, Gibrat’s law more or less holds. This says that growth is independent of size and so small stocks are no more likely to grow well than are big ones. In truth, this is intuitively plausible. If small firms tended to grow faster than big ones, we’d eventually end up with an economy in which all firms were the same size. But this hasn’t happened, and it is implausible.

But might the opposite happen in the short-term? Might we see mega-caps bounce back, in which case trackers would beat most active managers?

There’s a reason to think so. Imagine you owned a bond that paid you a regular annual income. Then unexpectedly in a year of recession this income was suspended with the promise of it being resumed in better times. The price of that bond would fall sharply, because what you thought was a safe asset turned out to be a cyclical one, and prices of cyclical assets should be lower than those of safe ones to compensate for their extra risk.

This of course is just what’s happened to banks and the oil majors this year. Their dividend cuts have shown these stocks to be more cyclical than investors thought.

Cyclicality, though, is a two-edged sword. It’s terrible in recessions but nice in recoveries. Cyclical stocks should do well in normal times to compensate us for their downside risk. And as mega-caps are now more cyclical, they should do better in the coming upturn (assuming we get one.)

We have, therefore a reason to suspect that UK tracker funds are actually more attractive now than they usually are – though the opposite is true of US ones – at least for anybody willing to take on cyclical risk.