Sleepwalking into a precarious situation is an unfortunate trait of financial markets. We don’t have to look a long way back into our history to find evidence of the last time investors focused on immediate benefits without considering possible long-term consequences: the stock market mania that become the dot-com boom and bust and the rampant trade in collateralised debt obligations that led to the 2008 credit crunch are prime examples.
After the global financial crisis, markets rose on the tide of quantitative easing and it wasn’t difficult to access good returns by buying trackers such as exchange traded funds (ETFs). A decade on and the popularity of cheap passive strategies, especially in the US, could be inflating a bubble. The root of the problem is simple: passive investing in market-cap-weighted indices means larger companies receive the lion’s share of capital. The biggest just get bigger. And the biggest companies of all are in technology.
Added to the fact that “our greedy equities are concentrated in those areas of the market which have favourable dynamics”, according to well-known investor Jonathan Ruffer, and big tech has been a major beneficiary of passive momentum, particularly in the US. The sector accounts for 24 per cent of the US large-cap index, largely thanks to the dominance of Facebook (US:FB), Apple (US:AAPL), Amazon (US:AMZN), Netflix (US:NFLX) and Alphabet (US:GOOGL) – owner of Google. These titans (together known as the FAANG stocks), account for 12 per cent of the S&P 500. They have a combined market capitalisation of $3 trillion and occupy the top three positions on the list of the world’s largest companies. Thus, a passive play on the US stock market has, in effect, become a bet on technology and the popularity of ETFs has provided significant momentum for the sector’s largest companies.
It may be unfair to say that day-to-day ETF trades distort the price movements of underlying shares, particularly as most of the ETF trading volume is done on the secondary market (providers vehemently oppose the notion that passive trackers adversely influence markets). But it is indisputable that a significant portion of the share capital of the world’s largest companies is now concentrated in these vehicles.
The three largest US-listed S&P 500 ETFs are managed by State Street Corp, BlackRock iShares and Vanguard. In total, these products are worth $510bn and account for about 2.24 per cent of the market capitalisation of the S&P 500. These large funds aren’t even the whole story. Add together all the passive strategies that hold S&P 500 stocks, including global tracker funds (which are heavily weighted towards S&P 500 stocks), ETFs listed outside the US and holdings in various smart-beta ETFs and the figure rises significantly. In July 2017, research by Bank of America Merrill Lynch found that 37 per cent of the S&P 500 was managed passively.
What’s worrying – but perhaps unsurprising – is that the largest ETF providers are also the biggest shareholders in major tech firms. For example, over7 per cent of Facebook stock is held by Vanguard, 6 per cent by BlackRock and nearly 4 per cent by State Street. Of course, all of this isn’t going to be in passive funds, especially in the case of BlackRock and Vanguard – although BlackRock’s last quarterly statement shows that two-thirds of the assets it manages are in ETFs and other passive vehicles.
And the valuation of big tech stocks has continued to be driven higher still by passive funds allocating capital on the basis of size and not fundamentals – thus creating a feedback loop. During the good times, investors enjoy the momentum provided by higher passive demand, in turn attracting further inflows from investors keen to ensure they don’t miss out on further upside. But the same could prove true in reverse – should sentiment turn, and if the belief that the tech giants will only ever get bigger weakens, then money could come rushing out, with wide-reaching ramifications. It is increasingly clear where this mood shift could come from: the FAANG companies are today being branded as anti-competitive, irresponsible or obstacles to innovation – investors are already rushing for the exit.
Big bad tech
Murmurings of unease that bubbled out of the European Commission in 2017 have hardened into a full backlash against the tech sector. The prevailing mood among consumers, regulators and politicians is that Facebook, Apple, Amazon, Netflix and Google have grown too big for their boots.
In 2017, the European Commission slapped Google with its biggest ever fine: $2.7bn for using its search engine to promote its own websites above those of paying customers’. Meanwhile, Facebook is being investigated by competition authorities in Australia who say it has too much dominance in the global advertising market; sharing 80 per cent of the digital advertising space with Google does indeed seem anti-competitive. George Soros thinks that the fact they are near-monopoly distributors makes them public utilities, which “should be subject to more stringent regulation”. He used his platform at the World Economic Forum in Davos to warn big US tech groups that “their days are numbered”.
And Mr Soros is not alone in taking a stand. In November, Margrethe Vestager suggested the dominance of US tech companies had “undermined democracy” and allowed them to “use fear and greed to drive anti-competitive behaviour”. As the EU’s competition commissioner, she has had a hand in fining Google for allegedly abusing its dominance in search, Facebook for providing misleading information when it acquired WhatsApp and Amazon for its ebook practices. She also opened an investigation into Apple’s tax practices following the publication of the Paradise Papers last year.
FAANG founders are no longer being praised for creating conglomerates that are uncontested on the world stage. Now, Mark Zuckerberg has been summoned by the UK government to explain how the personal data of 50m Facebook users was mined by political communications company Cambridge Analytica (an invitation he has declined). Larry Page of Google has been called out for stifling competition. Meanwhile, a widely praised Yale Law Journal article, ‘The Amazon antitrust paradox’, accuses Amazon of covert anti-competitive practices: “It is as if Bezos charted the company’s growth by first drawing a map of antitrust laws, and then devising routes to smoothly bypass them,” claims the article’s author, Lina Khan.
The 100-year old US antitrust laws seek to protect the consumer purse, but that is irrelevant when services are free or lowering prices for consumers – in the short term at least. Users of WhatsApp, Instagram and YouTube should probably note that their online activity is being collected and stored in the lower echelons of Google and Facebook. After all, if you’re not paying for it, you are the product.
No room for error
So, as customers and regulators have become more vocal on the misuse of personal data, investors have every reason to be wary – because the business models of these companies are dependent on the free flow of customer data, and their valuations dependent on flawless execution.
Take Amazon. If you were to buy a share in the company today – a transaction that would set you back $1,544 – you would be betting on 193 years of profitable future growth. True, analysts are expecting earnings to rise at a compound annual rate of 37 per cent between 2017 and 2019, but a price to forecast earnings ratio of 193 times would, on a PEG basis, demand an even faster rate of growth.
Unsurprisingly, bullish analysts choose to base their investment cases not on the group’s earnings forecasts, but on the sum of its parts. Revenues in its consumer retail business are expected to jump 65 per cent in 2018, giving it a potential market value of $501bn, while its highly profitable web services division is expected to be worth $310bn. Still, those valuations are predicated on the belief that recent growth rates will continue, and mean Amazon is a risky investment, even without looming regulatory pressures.
It’s a similar conundrum at Facebook and Google. Their valuations are far less inflated than Amazon’s but are still based on growth forecasts that suggest the two companies will keep making substantial profits from other people’s personal data for some time to come. If the result of the Cambridge Analytica scandal is a new wave of regulation that undermines these models, then the justification for exorbitant valuations in the sector will surely be called into question. Twitter (US:TWTR) and Snap (US:SNAP) have also suffered share price weakness in the wake of the Facebook scandal – their revenues are almost entirely reliant on the use of personal data.
Cut from a different cloth
It is easy to see how changes in anti-trust and data protection laws could stunt the growth forecasts of companies that make their revenues almost entirely from personal data. But a regulatory overhaul would not have an equal impact on the operations of all the FAANG companies. Commentators and investors frequently discuss them as one homogenous group, but they make their money in different ways that mean any regulatory backlash will affect them to varying degrees.
Take Amazon again. Sure, it has amassed huge quantities of personal data, but it has so far kept largely on the right side of policymakers and customers. In fact, aside from its poor contribution to the US government wallet, it has hardly put a toe out of line in its 24-year history – at least on the basis of the existing antitrust rulebook. Even splitting it up – as Massachusetts senator Elizabeth Warren and media theorist Douglas Rushkoff have called for – would leave investors with two Amazons and potentially create rather than destroy value.
It’s a similar story at Apple and Netflix, which have refrained from mega-mergers, have plenty of competitors and make money selling products, not data. World domination still seems a realistic prospect for these companies, whatever regulators throw at the broader technology industry – and partly explains why the recent technology sell-off has left them relatively unscathed. In short, technology investors should approach the sector in a much more selective way than has been the trend in recent years, paying more attention to business models and financial fundamentals. On any metric, for example, Apple still looks cheap – although like many in the sector its profitability is flattered by sophisticated tax planning.
Beware the edge
Even so, there remains the risk that these giant companies have been lifted together by the post-financial crisis boom in passive investing and could tumble together just as easily. We come back to that change in tech sentiment and the potential for wide-reaching ramifications in the US equities market. The reason? Active selling may, eventually, spark sales by passive investors and then, thanks to the quantity of tech stocks held in trackers, there is potential for a frightening selling loop.
For example, if investors begin to sell out of the large passive funds, the knock-on effect could be more downward pressure on the FAANG stocks. In turn, the weighting of these companies could spark further selling of the ETFs. Thus far, passive investors have avoided shifting stock as their active counterparts have done amid the wave of doubt surrounding the growth prospects of the FAANG companies. But that is not to say they won’t.
Market commentators have worried about the influence potential ETF selling could have in previous episodes. Speaking to Reuters about the 5 February volatility spike in US equity markets, JPMorgan flows strategist Nikolaos Panigirtzoglou was concerned ETF outflows could exacerbate selling.
He has found that the worst recent sell-offs occurred when equity ETFs suffer the biggest outflows, and he told Reuters in February that he was worried by potential reversal in retail investor inflows into US markets, which were exceptionally strong at the end of 2017: “If these equity ETF flows, which we believe are largely driven by retail investors, start reversing, not only would the equity market retrench, but the resultant rise in bond-equity correlation would likely induce de-risking by risk parity funds and balanced mutual funds, magnifying the effect of a market sell-off.”
Mr Panigirtzoglou’s analysis might equally be applied to any serious selling activity, and a collapse in confidence for such a significant sub-sector as the FAANG stocks could spook retail investors and spark ETF outflows. The feedback loops he was discussing pertain to asset allocation strategies, but this is part of a wider acknowledgement that potentially dangerous dynamics exist in markets because of the automated and robotic way money has been allocated.
ETF providers can point to episodes such as the taper tantrum or February’s spike in volatility as evidence they can resist the dangers we have set out in this article. But the fact remains these passive funds haven’t yet been tested in a sustained market sell-off. The trading mechanisms that have enabled ETFs to track the value of underlying assets could be placed under severe strain and the spark to fuel that fire could well be a change in data protection laws. We are describing a nightmare scenario that may not come to pass. But just as Facebook users have sleep-walked into a situation where use of their personal data can get out of control, it is possible financial markets have stepped blindfolded into another dangerous bubble.
