Mr Big Stuff? Is your CIP too reliant on mega-cap companies? And what can you do about it?

When something ‘works’ in markets for a long time you can assume more people will start doing that thing. As they do, they’ll drive its price upwards (making it a self-fulfilling prophecy), which persuades more people to do that thing. And so it goes on.

Until it doesn’t. When that thing starts to wobble, it can flip into reverse. First some of the early birds scatter, causing prices to fall. This makes another wave of holders decide to tiptoe out, which leads to steeper falls, and therefore more sellers. And so it goes on.

For you, the adviser, the questions are: Is there a ‘thing’ going on today? And, if there is, has my CIP become too reliant on it?

I’ve seen this – the rise and fall of a megatrend - play out a couple of times in my career. The first was the 90s internet bubble, which I witnessed from a junior, non-investing position (from where I could do no harm). But by the time the second wave peaked - the China/BRICs/Commodity Supercycle - I was managing funds, so had front row seats (thankfully I was the right side of it when it ended).

What was it like?

By 2007, the new commodities theme had been winning for five years.   Although – interestingly – for the first few years hardly anyone noticed, distracted by the implosion of the previous tech theme-turned-megatrend, and the endless will-it-won’t-it that surrounded it.

Emerging market equities were the most obvious beneficiary of the new megatrend. Not just because China and the other BRICs are themselves emerging markets, but also because that index’s largest companies were commodity and energy companies. But you could also ‘play’ it through specialist commodity or energy funds, or through active growth funds that were riding this wave. Even UK index trackers were unwittingly involved, as their biggest components were companies like BP, Shell or miner BHP Billiton.

After a brief interlude for the Financial Crisis, this theme ran until late 2011. Which meant all-in it lasted for over a decade.

Now, here’s the relevant detail for you and your CIP: When a theme has ‘won’ for as long as ten years, it stops being viewed as a theme and instead becomes simply “what happens”. As such, it becomes hard not to become overexposed to it.

Why?

A few reasons: Because many younger investment managers have only experienced that theme winning, so aren’t aware that it might not be a permanent state of affairs. So they load their portfolios up on it.

At the same time, older managers - with big mortgages - have either fallen in line or been sacked for not doing so. So they’re loaded up on it too.

And finally, marketing departments launch compelling funds dedicated to the theme, or hardwire an oversized exposure into the design of new multi-asset products. So new products are also loaded up on it.

The end result? Everything gets dragged towards that theme, like rubber ducks to a draining plughole. So, unless you take deliberate action to counter this, there’s a risk your clients will end up with too much of the theme du jour.

Is that a problem?

Well, it was last decade, just as it had been the decade before. Because eventually the commodity-slash-emerging-market theme buckled under its own weight, as the chart below shows.

Note that, as many folk back in 2012 assumed it would be, it was not a brief-but-painful correction then back to the races. Instead it was a brief-but-painful correction, followed by another one, followed by a short respite, followed by several more painful corrections. All adding up to 12 years – and counting – of clients being hacked off with any commodity-laden fund selections.

By 2012 I was old enough and grumpy enough to be royally irritated by just how long this trend had persisted (several years more than it should have, was my opinion at the time). It was a relief to watch it wobble then collapse, and our contrarian funds revelled in the experience.

This is, for the record, exactly how I’m feeling about today’s megatrend. Like the one that preceded it, it’s endured for more than a decade and has several beneficiaries that are all driven by basically the same thing.

What is that trend?

It’s been variously defined as ‘FANGs’ or ‘The Magnificent Seven’, but ‘Mega-Cap Growth’ is probably the best monicker (arguably we should add ‘US’ to that, as it’s also been a key component, although we’ve seen it play out in non-US markets too).

Intertwined with this theme is the move to passive index investing. So much so that it’s impossible to separate them, largely because as the mega-cap growth companies grow, they become a bigger part of the US and global indexes, which attracts more people to passive and/or mega-cap growth stocks, which pushes the prices upwards, making them even larger in the index. And so it goes on.

Here's how US Mega-Cap Growth companies have performed relative to the global index since 2010:

It’s important to emphasise the ‘mega-cap’ part of this theme, as ‘growth’ by itself hasn’t cut it. As this chart shows, small-cap growth stocks in the US have been left behind their wider market too:

It’s this aspect of the prevailing megatrend – overexposure to large companies - that most concerns me when I see many advisers’ CIPs.

Because, having seen this trend persist for a decade, it feels like history repeating: Many younger portfolio managers assume that mega-caps winning is just what happens (it isn’t);   older managers have largely fallen in line or been sacked for not doing so; and new products are being released with a mega-cap bias hard-wired in.

So, like rubber ducks to the plughole, many elements within advisers’ CIPs are being sucked towards the same assets.

Only time will tell when this particular megatrend will reverse, or indeed if it differs from all the previous megatrends by lasting forever. But if you’re keen to reduce the risk of a few lost years caused by being overly exposed to a collapsing trend, it’s something to consider.

This, naturally, is one of the ways we think we can help you with your business: We are structurally less exposed to mega-caps, and we aren’t about to change this. So, if you would like to deliberately diversify away from this trend, rather than being sucked towards it, adding a Downing Fox portfolio to your mix might help.

Here’s how our 100% Equity Portfolio looks compared to the Vanguard LifeStrategy equivalent (a fantastic product by the way, but by definition it has a lot of mega-cap exposure simply because that’s how index funds work):

Note how, in terms of Value vs Growth (left to right), the classic passive product is reasonably balanced, so the ‘growth’ part of the trend is less of an issue. But it’s not so balanced when it comes to market-cap exposure (top to bottom), as the bigger a company is, the more of it an index tracker will hold.

Fox100, in contrast, is more balanced by market cap. Partly because we designed it that way, but also because the active managers we hold are tiptoeing away from mega-caps on account of the increasingly unappealing valuations.

The Future?

There’s no way of knowing when the winds will shift from tailwind to headwind for a megatrend like this (if there was, I’d have done it years ago and put down a deposit on my own Richard-Branson-style exotic island).

That said, we’ve seen our portfolio behave less erratically than the market index of late, particularly when markets are falling. Maybe that’s a tell. Maybe not.

But one thing I can tell you for certain is I feel far more comfortable with my own money invested in our portfolio than in a market tracker, which means I can sleep soundly at night. I love a good kip, and I’d imagine you and your clients are no different, so on that front our funds are playing an important role.

Good luck out there,

Simon Evan-Cook

Fund Manager, Downing Fox

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Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.

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