The term the 'Internet of Things' is used to describe the connectivity and interaction between people, everyday products and services and computers.
Most investors have a general sense of the dominance of companies such as Facebook, Apple, Amazon, Netflix and Google (the so-called 'FAANG stocks').
Yet many are unaware of the magnitude of just how dominant these companies are.
The chart below demonstrates this point.
It shows that the market capitalisation in US dollars of six stocks connected to the Internet of Things - Facebook, Amazon, Samsung, Microsoft, Apple and Google - is greater than the entire size of equity markets in Japan, the UK and certain European countries.
Within the US equity market (the S&P 500), the five largest stocks by market cap when added together are roughly the same size as the bottom 350 combined.
If clients hold a passive US market cap equity tracker fund, their holdings in companies are determined proportionately in order of company size.
In the current Covid-19 environment, these five companies have done extremely well.
They have allowed people to maintain virtual connectivity, distribute content and maintain a global marketplace in the absence of face-to-face contact or physical marketplaces.
So, you might ask, what’s the problem?
The threat of disruption
The disruption of business models has long been a function of markets.
But arguably the pace of disruption has quickened in the past decade due to the speed of global commercialisation and the take-up of technological advances.
This pace of change has come specifically in the way people communicate, access entertainment and buy products and services.
In today’s environment, disruption is likely to occur in three ways:
- Another company begins to offer better products and/or services, winning and then dominating market share. This is essentially what happened to Nokia
- There's a significant shift in the supply or demand dynamics, with existing products and services made obsolete. Two regularly quoted examples here are Kodak and Blockbuster
- A structural problem created by poor environmental, social and governance practices that severely impacts forward-looking earnings. Examples might be labour conditions, data privacy breaches, tax policies or questions over ownership and independence. The company could then be punished by market forces or regulatory pressures
As a result, US passive equity investors need to be comfortable that these large companies can react and deal with disruption from their smaller competitors when the time comes.
Whether they know it or not, these investors now have a disproportionate amount of faith in a very small number of companies to deliver their investment returns.
Ironically, this characteristic is often connected with high conviction active investors rather than passive investors.
An alternative approach
We believe that when using passive investment, risk control should be considered as part of the index composition or index selection.
Market cap indices are cheap, but don't provide a natural mechanism for managing stock or sector concentration if this becomes an issue.
The alternative is to construct another trackable index using a set of different rules - one that rewards companies with a higher weighting if they satisfy certain criteria, rather than simply because they happen to be very large.
By focusing on a number of factors which have been seen to deliver stronger risk-adjusted performance after fees over time, these can be used to determine the weight of each stock in the index.
These factors might include:
- value (stocks that appear cheap)
- low volatility (stocks with lower volatility)
- quality (high quality companies)
- size (smaller companies)
There may be other factors you can overlay in line with what clients want.
These might be excluding companies involved in the production of weapons, reducing exposure to companies with worse than average carbon emissions or increasing exposure to companies generating 'green' revenues.
To achieve good value for money and the desired split between different geographical regions, it's worth looking at a mixture of market cap and factor-based equity funds.
We believe this provides efficient fund fees, a good level of diversification, and access to the regions and factors which should hopefully work to add value over the long term.