Investment
Is this another diversification trap?
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In the wake of the global financial crisis (GFC), index ETFs were meant to offer risk-averse investors a safe and easy way to gain diversification. But nine years into the global market's bull run, they appear to be pushing US tech stocks into unrealistic valuations in ways that may end badly for many.

In late 2018, we are at a fork in the road where investors may want to reconsider their strategies. The trillions of dollars flowing into ETFs peaked in March and we're starting to see tech stocks return to earth. The FAANG stocks, which include the likes of Amazon, Facebook and Google, lost a combined US$172.7 billion in value on 10 October alone.

This paper discusses our view that ETFs are a bubble that are in turn a transmission mechanism for a tech stock bubble. And that many investors in ETFs that follow indexes are as exposed as those who bought into collateralised debt obligations before the GFC.

It also discusses the opposing regulatory and consumer forces that might pop the bubble, especially among tech stocks, and open up buying opportunities.

As the nine-year bull market has progressed, we have seen United States (US) index fund investors become over dependent on a hyper-narrow band of technology stocks. Today we stand on the resulting precipice - the investment universe has not seen so much capital concentrated in a single sector that, through convenient products, can be sold at the click of a mouse.

Meanwhile the emerging perception of regulatory risk will serve to remind investors again that projecting hyper-returns on equity out to infinity, to justify stratospheric share prices, is not a valid investment methodology.

Last year, during our presentations to financial planners and their clients around the country, we began underscoring several important observations.

The first was that the proportion of the market's high returns that had been delivered by a handful of mega-cap tech stocks was historically unprecedented. The second was that as index exchange traded funds (ETFs) grew they were forced to invest ever greater amounts in these larger companies, irrespective of price or profit outlook. And finally, we noted that the stock turnover of the major US index ETFs was significantly higher than the turnover of even their largest holdings. While this would lead to a combination of high returns, and low volatility on the way up, the reverse would be true when investors began exiting.

We now appear to be at a fork in the road. There will be overreactions as higher quality tech companies are thrown out with the proverbial bath water. Such events will present opportunities for savvy investors. There will also be many traps.

In this whitepaper, we alert investors to the dangers of heavily tech-weighted US index funds - arguably one of the biggest fads investors have ever seen. We also argue that the consequences of an over-reliance by US ETF investors on the prospects of a narrow band of tech companies will impact investors in other regions and other asset classes, presenting mouth-watering opportunities.

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