The Feedback Loop at the Center of Markets

Intro

I want to talk about something that affects everyone reading this, whether you copy me, hold an S&P500 ETF in a 401k or ISA, pay into a pension fund without much thought, or pick your own stocks. The market has a mechanism that warps performance, benchmarking, and influences valuations across the market.

Index funds, and the growth in index investing.

Before I dive in, I want to be clear that this isn’t a doom post, it's not me telling you to sell your index funds or change strategies. They remain an important, accessible tool for all types of investors to help build wealth. But I think there’s a feedback loop building under the surface that a lot of investors are not fully aware of, or do not consider. As someone who measures myself against the S&P500 and Nasdaq100 every day, this is something I think about often.

The Mechanism

The largest indices - the $SPX500 and the $NSDQ100 - are weighted by market cap. The bigger the company is, the larger its slice of the index is. That sounds sensible, and for decades it worked well. But it means that when money flows into index funds, it isn’t spread evenly, it is allocated based on size. The biggest companies get the biggest share of every dollar invested.

The problem is that Index tracking ETFs have become extremely popular, both for retail investors, and institutional investors. Plenty of investors here on eToro use these funds as part of their portfolio, or maybe even all of it. In the US peoples 401(k)s, in Europe their workplace pensions, and in the UK their stocks and shares ISAs are often set to automatically buy more every month or quarter. Even the funds people deposit in banks or hold on crypto exchanges often ends up to some extent buying into the S&P500 or Nasdaq100.

Regardless of how the top companies are performing, or their valuation there is a steady stream of buyers.

The Feedback Loop

You can probably already sense where I’m going with this.

The larger a company's weighting grows, the more passive buying it attracts. The more buying it attracts, the more its price rises. The more the price rises, the larger its weighting becomes. Of course, that doesn’t tell the whole story. nVidia wasn’t always among the top 10 weightings of these benchmarks, they got there on merit - through growth of the business. But passive flows make these companies sticky and harder to unseat.

Fundamentally, even though you buying shares doesn’t directly give the business any cash. It does help them secure more favourable financing. This in turn means that even if the company isn’t innovating, they can more easily buy their way into new markets using mergers and acquisitions, often largely paid for with stock, not just cash.

Plenty of investors have been aware of this problem for a long time. It’s very common to see a company share price rally even at the mention that they could soon be included in a major index like the S&P500.

The Benchmarking Problem

One problem investors and fund managers face is that for better or for worse, most people measure their returns against these large indexes. This is in many cases, a completely unfair comparison. Indexes are in many ways the world’s biggest Popular Investor - Millions of people are copying the portfolio every day, helping inflate prices for everything held in the index. So beating an index consistently, really is quite a big achievement.

On top of that, the companies at the top of these indexes are a monumental influence on the overall performance. The top 10 holdings in the S&P500 have a total weighting of more than 36%. The top 25 combined are worth more than the remaining 478 (yes there are 503 total holdings). The Nasdaq100 is even worse - The top 10 holdings represent almost 50% of the index.

My portfolio, as most of you are aware, takes a socially responsible investing approach. I avoid companies that I believe are actively detrimental to society, and aim to invest in companies that actively do good. This is much easier in some industries than others. This of course makes the Nasdaq100 and S&P500 even less of a fair comparison. They have no such restrictions, so trying to compete on performance while defense companies and oil companies are dominating market returns is extremely difficult.

I of course know this, and accept it, but many investors and copiers often forget that different funds and copyable Pro Investors have their own strategies that simply can’t always compete with the mainstream benchmarks.

Risk & Opportunity

The first risk is what happens if inflows slow or reverse?

The same mechanism that benefits larger companies when money enters the market will hurt them the most if money leaves the market. The aging boomer population has already started drawing their pensions, but it’s gradual, and as they age further, much of their wealth will be inherited by people still saving. The bigger risk to me is the rapidly rising bond yields we have seen globally over the past year. Why buy over-valued stocks when you can get a ‘risk-free’ return that’s increasingly competitive.

I think for now the risk of flows reversing remains small, but it’s something we should keep in mind.

Another risk is simple lack of diversification. The Nasdaq especially has largely become a bet on 6-7 large US companies in broadly the same sectors and industries - Tech, AI and Semiconductors. Any event that specifically hurts these areas of the economy would severely hit performance. There is a false sense of security in owning these large indices. They feel safe right until they don’t.

The opportunity is unfortunately something easier said than done. Find the underpriced value that is on track to push towards the top of the indices. If the top end carries a price premium, and smaller companies carry a price discount, then the potential alpha for finding the rising stars is even larger. Ultimately, this is what stock picking and investing is all about, and the staggering returns of $MU $NVDA and others over the past 12-24 months highlights just how big the reward can be.

Closing Comments

Before you go abandoning your index funds, I need to stress that for the majority of people these are fantastic investment vehicles, there is a reason they became so successful. The point of this post is not to sow seeds of doubt, but encourage people to understand what they own and what they are measuring against. More importantly, it’s about recognizing that decades of people doing the sensible thing has actively changed the rules of the game.

As always, these are my own thoughts, not financial advice. I’d love to hear your opinions in the comments. Are Indices becoming a systemic risk? Are the markets just unfair? Is this all just part of the game?

Thanks for stopping to read this, and for following/copying if you do. Please give the post a like if you found it useful, and consider following or copying my portfolio if it aligns with your financial goals and objectives.