News & analysis


BLACK SEPTEMBER AND THE TALE OF THE SHRINKING STOCK MARKET


What does the falling number of listed stocks mean for investors? Mona Dohle finds out.


Tuesday 13th September was a bad day for investors in US equities. Higher than expected US inflation figures sent the stock market sliding by more than 4%. Within hours, more than $1.6trn (£1.4trn) was wiped off the index’s value. Most institutional investors would have steered through that day like any other, knowing that some of their losses would eventually be recouped. But there is an interesting fact about this crash that is worth considering in more detail: some 40% of the losses booked in the S&P500 came from 10 firms, with the big tech stocks dragging the entire index down. Apple, the index’s most valuable constituent, lost more than 10% through- out September while Microsoft’s share price shrank by more than 14%. This speaks volumes about the level of concentration in US equities. Should investors be worried?


Take five


The shrinking universe of listed companies across high-income economies is not a new trend. Since the mid-90s, the number of firms trading publicly in the US has halved to around 4,200 from 8,000. In London, there were almost 1,900 companies for investors to analyse, down from 2,900 in 2006, according to the World Bank. The growth of private equity and an increase in mergers and acquisitions are among the factors influencing this trend. But it is worth examining whether this trend has been suffi- ciently reflected in institutional investment portfolios. Since 2006, defined benefit schemes have reduced their exposure to listed equities to 19% from 61%, largely due to their changing demographic. But defined contribution (DC) schemes rely heavily on listed equities to grow their assets. The average DC scheme has more than half (54%) of their assets held in equities, according to Mercer. And because most of that exposure is sought through tracking or replicating developed market indices, such as the FTSE100 or S&P500, DC schemes remain exposed to a shrinking number of companies, which may not even accurately reflect the key drivers of economic growth. For example, the S&P500, which is market cap based, remains heavily concentrated in tech stocks. Indeed, the big five, Apple, Microsoft, Amazon, Tesla and Alphabet, account for 23% of its value, despite the information technology sector only adding around 5.5% to US GDP. A portfolio institutional survey showed that the investment strategies of the biggest UK master trusts are heavily concentrated in these tech stocks, leaving them exposed when the index is slumping.


Shadow index


And DC investors are not the only ones. It is notoriously hard to gain a full sense of the scale of passive investments. Official figures by the Investment Company Institute show that index mutual funds and ETFs own 16% of the US stock market. But besides index funds and vanilla ETFs, there are a growing number of shadow index investors, for example, institutions such as DC schemes, which replicate indices in-house. A paper by Alex Chinco, assistant professor of Finance at Baruch College, and Marco Sammon, assistant professor of Finance at Harvard Business School, argues that the scope of shadow indexing is much higher than the official indexing fig- ures suggest. The paper claims that more than 37% of inves- tors in US equities tracked either the S&P500 or Russell’s 1000 or 2000 indexes. Sammon and Chinco’s estimate is based on a study of the vol- ume of index additions and deletions on reconstitution days, the days when indices announce changes to their composition. Their research highlights how an ever-growing volume of financial assets is chasing an ever shrinking number of compa- nies. A fact that should alert DC investors, especially on days like the 13th of September.


Diversification


Stock market concentration could also be a concern from a governance perspective. Share ownership for the limited num- ber of companies that have made it to the top of the wealthiest equity indices is, not surprisingly, increasingly dominated by index providers. Nearly half of all companies (45.9%) in the MSCI All Countries index are classed as controlled, meaning that the largest share- holders hold more than 30% of the voting rights. Little has changed in the past seven years, with the level being 31% in 2015. Vanguard and Blackrock own more than 30% of the MSCI USA Index Market Cap between them, a research paper by Ric Marshall and Jonathan Ponder of MSCI shows. “Ownership interests and voting power at principal shareholder and widely held companies have become more concentrated in the hands of a relatively small number of large investors,” the paper read.


The authors argue that these changes in governance mean investment risks change. When investing in companies with a concentrated ownership structure, investors should consider whether the board’s decisions could favour controlling share- holders over other investors.


This also raises the question to what extent are UK institutional investors able to influence ESG policies, such as tackling cli- mate change, when their biggest equity holdings are concen- trated in companies dominated by index funds. All the more reason to re-think the importance of portfolio diversification.


Issue 117 | October 2022 | portfolio institutional | 7


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