New measure shows ‘orange/red signal’ warning of cap-weighted benchmarks’ increased exposure to shocks
Investors in index funds may expect to get a measure of safety from quick one-shot diversification, but new research suggests that they’re getting more risk than they bargained for.
In a research paper expected to be released this week, index provider Syntax has found that investors in the current market environment are racing concentration risks comparable to periods those in the late ‘90s run-up in prices of technology stocks.
“Several core market-capitalization-weighted equity indices, which are considered to be diversified, are now exhibiting elevated levels of a new measure called active business risk,” reported Institutional Investor.
As defined in the paper, business risk represents the potential threat from an index being tilted too much toward a particular sector. That’s as opposed to having an overall neutral market position, which index-fund investors generally expect along with good diversification.
“When [active business risk] is low, the index is broadly diversified,” Syntax research director Simon Whitten said in an interview with the publication. “From 2009 to 2018, the market wasn’t that vulnerable to shocks. We’re starting to get an orange/red signal that the market is taking more risk than usual at the industry level.”
According to Whitten, cap-weighted benchmarks have started taking on more business risk than usual; with increased exposure to companies saddled with similar weaknesses and external threats, indexes are likely to experience more volatility.
The Syntax paper, which Whitten co-authored with Syntax CEO Roy Riggs and senior vice president Jonathan Chandler, found that the S&P 500 carried an active business risk level of 23.2% at the end of September.
“This is above its long-term average due to the oversized exposures to certain technology-related business risks,” the paper said. While the index has not reached the critical levels observed during the worst of the dot-com bubble, its active business risk was consistent with periods of poor performance.
Noting the frequent occurrences of smaller scale sector booms and busts, the authors said that such events are usually coupled with weighting imbalances because of how “simplistic” market-cap-weighted indices are. Because of that, investors may be taking significant positions in market segments that they do not want without realizing it.
Syntax also found that following periods when the S&P 500, S&P 500 Value, and S&P 500 growth indices exhibit business risk levels above the 75th percentile, the benchmarks showed significantly lower performance.
“In March 2000, the problem was a weighting problem,” Whitten said. “[P]eople who bought a passive index fund … ended up being massively overweight in tech when it was at its most expensive. That’s playing out right now.”
