Sometimes in markets, good ideas go wrong. What starts out as a sensible approach to investing begins to morph, eventually becoming something quite different from its original intent. Take credit ratings, which originated as a way to evaluate the creditworthiness of a single bond. A perfectly sensible idea, they grew in importance for decades before being applied to increasingly complex structured instruments backed by large pools of sub-prime loans—a very different proposition. Awarded AAA ratings, these were distributed far and wide by banks. When defaults began to rise within these opaque products, they became a catalyst for the Global Financial Crisis of 2007–2009.
In many ways, the index fund has also been a good idea, providing an easy, low-cost way for investors to achieve average market returns. Very few investors can routinely beat the market, and so the index fund industry has grown rapidly and is now huge, with an estimated $40 trillion under management. Index funds really matter. Unfortunately, they’re also changing, and in an insidious manner. Here’s what’s going on…
It’s probably not escaped your attention that three large and well-known private companies are planning their IPOs this summer. The sheer scale of the offerings, and the audacious valuations being mooted, pose a vital question for the investment banks enlisted to sell them: who is going to buy all these shares at the proposed prices? To put some numbers on it, the first of these IPOs, SpaceX, is seeking to sell around 4% of the firm for $70bn. Using numbers from SpaceX’s registration statement, we estimate that these shares will have a price to book ratio of 52; a price to sales ratio of 96; and, as it’s a loss-making firm, no P/E ratio – it’s a bold ask! We would also argue that future cash flows are highly uncertain and that corporate governance is, er…unorthodox.
Perhaps index funds will buy these shares? However, most good indices don’t permit unseasoned stocks. Some, such as the S&P500, don’t permit entry by loss-making firms. These rules are sensible, but they’re a problem for the stock promoters. What to do?
Enter the solution in the form of two new technical papers: the updated ‘NASDAQ Index Methodology’ and the ‘Nasdaq-100 Index® Methodology Changes’ papers, both published this May. The big change is that the NASDAQ-100 now has a ‘fast entry’ mechanism for very large IPOs. Instead of waiting three months or more before they could enter the index, SpaceX-sized IPOs can now be added after roughly 15 trading days. Once a company enters the Nasdaq-100, index funds tracking it effectively become forced buyers, regardless of price. And if you were a trader and you knew that there’s a forced buyer at any price in 15 days’ time, well, you’d buy it and hope to squeeze that price higher. It’s called predatory trading and it provides immediate demand for the shares.
As to what’s going on here, take your pick of nouns: a shimmy, a shenanigan, maybe even a scandal. NASDAQ themselves say that there have been developments in private markets, and so “the Nasdaq-100® must adapt to this changing environment.” Just like the credit rating agencies adapted to the changing environment prior to the GFC.
Ultimately, it’s pension funds, charities and retail investors who own index funds. The ultimate buyers won’t have chosen these new shares. Instead, the shares will have been put on them. In this hustle, they’re the mark.
All long-term investors need to understand this game, and act accordingly. It’s vital to think for yourself and to invest independently of indices. And if you’re invested via active funds, find out if your funds are different from the index. The simplest statistic that measures this is the active share, the proportion of a fund that is not an index constituent.
One of Kennox’s founding principles is: “we don’t care what’s in the benchmark”, and with an active share of 99%, the Kennox Strategic Value Fund is clearly still true to that founding principle. This matters, now more than ever.
Written in collaboration with James Clunie