Big, fat and bloated. Index funds rule the roost, but should they?

Risk – at some level – is intrinsic to any investment, but diversity is a choice. And when it comes to diversity, Dollar Bill is not talking about all that woke nonsense that seems to be gripping the corporate world by the short and curlies. I’m talking about that super-diverse investment category of index funds, the practise of investing in a fund that invests in pretty much every company in a particular market. 

Index funds now command more money and house a greater slice of global equity investment than ever before.

In the United States alone, more than half of all money invested in equity funds is now tied up in index-tracking products - up from just a fraction of the market a few decades ago - with capital flooding into low-cost, “set and forget” strategies. But given the weight of money flowing into so many index funds, the inherent risk of index investing isn’t only their inability to outperform, but also the exposure to systemic risk they increasingly present.

Dollar Bill has long suspected the most dangerous word in investing isn’t “risk” or “volatility” - it’s “diversity”. Index funds are sold almost exclusively on the benefits of diversification. It’s what investors whisper to themselves as they pour money in, hoping to sleep more soundly at night, comforted by the idea that hundreds of companies must surely mean hundreds of different bets and less volatile movements.

But there are two problems with this; one, it lacks any semblance of conviction, and two, it’s total bunkum. 

There’s a quiet joke that’s been doing the rounds at the club for some time, mostly aimed at a few of the younger members. While the kids are preoccupied with diversifying and debating which index fund one broker recommends over another, somehow they all end up owning the same stocks anyway. Different portfolios. Different platforms. Different wrapping paper. But lift the lid, have a proper look and it’s the same handful of names staring back every time.

For any large-cap US index fund, it’s impossible to avoid the so-called Magnificent Seven - Nvidia, Apple, Microsoft, Amazon, Alphabet, Meta and Tesla. These companies do almost all the heavy lifting, accounting for about a third of the entire S&P 500. Back home, the Australian market is hardly any better, with the big four banks alone making up about a quarter of the ASX 200. Add in BHP, CSL, Macquarie and Fortescue and you’ve got half the index covered - and that’s before you’ve glanced at anything else. Even if you’re considering a top-200 or top-300 index fund in search of diversification, you can’t escape it. What you really end up holding is heavy-ended concentration, only with branding.

Buying “the market” today isn’t the broad safety net it sounds like. It’s a bit like lending money to the same five questionable mates and calling your loan book diversified. It wasn’t always like this. Indices used to be broad churches. These days, they’re more like the Latter Day Saints.

Take a step back and it’s easy to see the whole thing is faintly absurd. It’s money chasing money and advice following advice. Fund managers hug the index, whatever the index, because nobody ever got fired for owning what everyone else owns. Independence generated from the nerds in the backroom at the local fund manager has become almost impossible to sell. It’s far safer - career-wise at least - to be wrong in a crowd than attempt to be right on your own.

What follows is predictable. Stocks simply keep getting bigger – fatter and more bloated - for no reason other than they sit inside a given index. As more money flows in, prices push higher, attracting more money, which pushes prices higher again. It’s less a market and more a feedback loop with a Bloomberg terminal.

And with the advent of superannuation funds, the world has become awash with big money that needs big homes – enter the index fund – the perfect depository for a dump truck full of money… or is it?

Concentration would be one thing if the prices were sensible, but they’re not. And here’s where Dollar Bill’s head first starts to spin. Commonwealth Bank shares nearly doubled last year. It didn’t double earnings. It didn’t double dividends - it only doubled its price. Shares in ANZ, Westpac, NAB and Macquarie all joined the same party. Charts that used to crawl north have recently started sprinting like some of the old miscreants at the club do when some lucky punter occasionally rings the bell and buys the bar. Trying to justify some of these moves with straight-faced maths feels a bit like doing tax returns with a hangover. Technically, it’s possible, but you’re never entirely convinced the numbers add up.

Profits haven’t exploded. The economy hasn’t suddenly discovered rocket fuel. The stocks are just bigger because more money keeps piling into the same names simply so fund managers can go as close as possible to matching index returns. It’s the same story in the US, only with more zeros.

When it comes to US index funds, consider some of the valuations you’re buying into. Amazon and Alphabet trade around 30 times annual earnings – that is to say, if you bought 100 per cent of either of these two companies, it would literally take you 30 years to get your money back. Market darling and AI chipmaker Nvidia is nudging 50 times annual earnings! That number always makes Dollar Bill’s left eye water. At that sort of multiple, you’re effectively waiting half a century to earn your money back.

Even back at home in Australia, valuations are getting all stratospheric at the top end. Those dominating local index funds are verging on the extreme, with Commonwealth Bank trading close to 30 times annual earnings, while the other three of the big four banks are trading at ratios of around 20 times. And it’s not as if these valuations are attached to new tech stocks promising exponential growth down the track - these are the current PE ratios for 100-plus-year-old banks!

Dollar Bill reckons you’ve got to admire the optimism required to fund those sort of promises. This is the kind of arithmetic that only really works after a long lunch, or when you’re trying to convince a recently divorced and far younger dinner companion that your best years are still ahead of you.

It’s almost as though research, analysis and subsequent conviction don’t matter anymore, and annual dividends are becoming the poor cousin when compared to seemingly never-ending capital appreciation. 

To be fair, though, when it comes to index funds, if you’re happy merely matching market returns, passive investing works just fine. Buy the ETF, go to lunch and let the averages do their thing. There’s nothing inherently wrong with average returns if average is what you’re chasing. But Dollar Bill has never been at all interested in average. The Dollar prefers a little alpha sprinkled on his cornflakes.

All evidence - and logic - particularly down the small-cap end of town, suggests you’ll never get outperformance by simply owning what everyone else already owns. You only get it by doing the work, reading the footnotes and kicking the tyres. Backing your own judgement when the crowd looks the other way is fundamental. Plenty of professional investors have quietly built careers following these exact steps.

Take the fund manager Ophir, for instance. Its Opportunities Fund typically runs a tight book of just a few dozen stocks outside the ASX top 100. It has no closet indexing, no 200-stock safety blanket, just conviction and a penchant for a bit of a punt. Over the past year, Ophir has posted returns north of 35 per cent. More importantly, over three years, it’s delivered roughly 32 per cent per annum and over five years about 21 per cent. All these returns sit comfortably ahead of the small-cap benchmark, but Dollar Bill reckons performance like that, as impressive as it is, can be hard to keep up year after year.

Firetrail’s small companies strategy tells a similar story. Theirs is a concentrated portfolio of roughly 30 to 50 names which has delivered more than 30 per cent over the past 12 months and returns in the mid-20s per annum over three years - again materially ahead of the Small Ordinaries and again Dollar Bill likes to ask the question, when will that party stop? Seneca is another specialist with a tight book that consistently shows up near the top of the tables, regularly punching out annual returns in the mid-20s. None of these managers are magicians. They’re only doing something that now seems unfashionable: research, analysis and the application of independent thought and yep, there is probably a bit of luck and timing involved and just because one year is good, it doesn’t always mean the next one will be. But Dollar Bill still likes to compare these funds with the index funds some of the trust fund babies at the club like to put their money into, just for fun. 

When it comes to index investing, while the herd crowds into the same mega-names at stretched multiples, managers operating on conviction and research are rummaging around in the forgotten aisles where prices still vaguely resemble value. They’re hunting smaller companies the market hasn’t quite figured out yet, and that inefficiency is another word for opportunity.

It’s also worth noting when the multiples on brand-name stocks stretch as far as many have today - mostly thanks to index inflows - everyone suddenly starts describing those earnings as “quality” instead of “expensive”. It’s funny how language changes with price.

But of course, something can always go wrong. A guidance miss. A funding hiccup. A regulator with a clipboard. Then, all of a sudden, half the market is trying to squeeze through the same exit at once. Anyone who’s been around the block has seen this movie before. When everyone owns the same five chairs, you don’t need a fire. You just need someone to bump the table. Famously, there was the Nifty Fifty in the ’70s. Then came the dot-com darlings a few decades later, followed by the banks pre-GFC. Every era has its “can’t lose” list, and so many of these names are now marked forever in the history of infamy.

It’s at this point that the slightly boring investors start to look clever. Here we meet the value crowd. These are the guys at the club still muttering about price-to-earnings ratios like it’s 1998. These are the guys still reading annual reports while everyone else scrolls headlines. They understand shares aren’t stories, but rather, they are potential streams of cash. And you either pay a sensible price for those cash flows, or you don’t buy them.

Consistently, over time, successful investors obsess over the same dull questions: How much does it earn? What does the balance sheet look like? What am I paying for each dollar of profit? And if there aren’t earnings yet - who’s running the show? Dollar Bill reckons the last one matters most in the small-cap world. A board that’s built and sold mines, drugs or tech businesses before usually finds a way to do it again. And someone who has been kicking around public markets for decades but has never threaded one through the goal posts is unlikely to sneak a goal just as you come into the team.

While the herd is paying 30, 40 or 50 times earnings for the comfort of “certainty”, the homework crowd is quietly buying cash flows at half the price. And it’s in that gap, between price and value, where outperformance lives. So maybe the most dangerous word in investing is actually “diversity”. It tricks you into thinking you’re safe, it makes you feel all warm and fuzzy when all you’ve really done is join the same queue as everyone else, and Dollar Bill has never liked queues. 

If the whole market is sprinting in one direction, Dollar Bill instinctively likes to go the other way, to have a punt, to collect the big cheques and God forbid, if they go south, nobody will ever know that Dollar was all in – after all, that’s the unwritten rule at the club – always talk about the wins……but never the losses.

Is your ASX-listed company doing something interesting? Contact: matt.birney@businessnews.com.au