The “Internet of Things” is a term used to describe the connectivity and interaction between people, everyday products and services, and computers. While most investors have a general sense of the dominance of the companies involved and may have heard of different acronyms for groups like ‘FAANG1 stocks’, most are unaware of the magnitude of the dominance.

    The chart below shows that the market capitalisation - allowing investors to understand the relative size of one company versus another- (in USD) of six stocks (Facebook, Amazon, Samsung, Microsoft, Apple and Google), which are connected to the Internet of Things, is greater than the entire size of the equity markets of Japan, the UK, and individual European countries. 

    MSCI_hymans2020

    Within the US equity market (S&P 500), the 5 largest stocks by market cap when added together are roughly the same size as the bottom 350 combined, shown here:

    If you hold a passive US market cap equity tracker fund, your holdings in companies are determined proportionately in the order of size shown in the above chart. In the current COVID-19 environment, these five companies have done extremely well as they have allowed people to maintain virtual connectivity, distribute content and maintain a global marketplace in the absence of physical connectivity or physical marketplaces. So what’s the problem?  

    Will these business models suffer “disruption”?

    The disruption of business models has long been a function of markets. However, in our opinion, the pace of disruption has quickened in the past decade due to the speed of global commercialisation and take up of technological advances, specifically the way people communicate, access entertainment content 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 against Nokia. 
    • There is a significant shift in the supply or demand dynamics in the markets being operated in.  The existing products and services being made obsolete. Two of the most commonly referenced case studies here are Kodak and Blockbuster. 
    • A structural problem created by poor environmental (perhaps less relevant in the above-mentioned companies), social (labour conditions, data privacy breaches and tax policies) and governance (ownership, voting and independence) practices that severely impacts forward-looking earnings. The company could then be punished by market forces or by regulatory pressures.  

    What does this mean for US passive equity investors?

    • These investors need to be comfortable that these large companies can react and deal with disruption from their smaller competitors when the time comes. 
    • These investors, knowingly or unknowingly, 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.

    The IMX alternative

    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 do not 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 that rewards companies with a higher weighting if they satisfy certain criteria, rather than simply because they happen to be very large.

    The IMX approach is to focus on a number of factors which have been seen to deliver stronger risk-adjusted performance (after fees) over time, and to use these factors to determine the weight of each stock in the index. The four factors currently used within the strategy are: 

    • value (stocks that appear cheap)
    • low volatility (stocks with lower volatility)
    • quality (high quality companies)
    • size (smaller companies)

    The index assigns a higher weight to stocks which rank highly in one or more of these factors, relative to the market cap index.  

    The index selected by IMX also includes a climate change and controversial weapons overlay, which has the following effects:

    • it excludes companies involved in the production of weapons which are prohibited under international treaties.
    • it reduces exposure to companies with worse than average carbon emissions and fossil fuel assets within their sector. 
    • it increases exposure to companies which are generating revenues from the green transition. 

    To achieve good value for money and the desired split between different geographical regions, IMX has adopted a mixture of market cap and factor-based equity funds. This provides efficient fund fees, a good level of diversification, and access to the regions and factors which we believe can add value over the long term.

    [ 1 ] Facebook, Apple, Amazon, Netflix and Google

    Catherine Miller

    Investment Manager, Hymans Robertson

    Risk warning: This communication has been approved and issued by Hymans Robertson LLP (HR) on behalf of Hymans Robertson Investment Services LLP (HRIS) and is based upon their understanding of events as at date of publication. It is designed to be a general summary of topical investments issues, it does not constitute investment advice and is not specific to the circumstances of any particular financial advisory firm. Please note where reference is made to legal matters, HRIS is not qualified to provide legal opinions and you may wish to seek independent legal advice. HRIS accepts no liability for errors or omissions.

    stocks-chart