- Friday 28 August 2020
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Markets and The 'Ruud Gullit Effect': When the outlier drives the average
With the recent passing of Jack Charlton, a lot of really interesting and poignant pieces appeared in the media discussing the impact the man, and his Irish teams, had on the nation. For those of us who grew up football-mad in the 80's, it was amazing to recollect those scenes from '88, '90 and the rest.
For me, those 'Charlton Days' articles & programmes brought one particular memory, a maths lesson I had in school, sometime in 1987, that stuck with me ever since. Our teacher at the time was crazy about football, and the biggest event of the year, before we qualified for Stuttgart of course, was Ruud Gullit's transfer from PSV to Milan, which broke the transfer record at the time (and no homework if you could tell him what little Argentinian genius was the previous holder!).
On top of the fee, the move was set to make Ruud the highest paid footballer in the world, and for those of us convinced that a career in soccer was a nailed-on certainty, his weekly wage something we excitedly discussed. Smart man that he was, our teacher used our interest to introduce the concepts of average and mean in the context of footballer salaries, which of course guaranteed our interest.
He first blew our minds in telling us that the average weekly wage in professional football was £1,200, an astronomical figure for a bunch of 9 year olds in 1987. But our bubble of excitement was burst when he explained that the mean wage was not quite so amazing, patiently demonstrating how the salary of the very top players completely skewed the average, with the vast majority of footballers surviving on much, much less, thereby dampening our future lifestyle expectations even before our actual football skills finished the job.
Had we been a smarter class, he might have gone on to expand on this topic and explain that, over time, the news was much better for us. With a decade still to go before we'd 'make it', Ruud's huge wages would, as outliers do, become the norm, when the top becomes the centre, thereby driving up the average. This statistical constant has certainly been a boon to footballers, who have seen their wages shoot up hugely in the decades since, with transfer fees showing the same massive increases. But if we reflect on it properly, it also shows us that our natural instinct of caution, or downright scepticism and contempt, when we hear a new record wage or fee, for example Messi and Neymar in current times, can often be misplaced.
So I’m thankful to Mr O'Neill, and the understanding he gave me about the impact of ‘outliers’, those data points on either end of a group range. When it comes to statistical analysis, remembering the astonishment of those record transfer fees & wages at the time, and how quaint it all seems years later, is very useful in the world of Investment Markets, where the temptation to resist and fear 'new highs' has no real basis in historical fact.
MARKET CAP WEIGHTING: THE BEST DRAG THE REST
As the owner of a Financial Planning & Investment Management Firm, offering access to global equities (including large cap & factor) and smaller niches such as ESG and Disruptive Tech, we recognise that the performance of outliers genuinely impacts the entire data-set in ways that are both entirely predictable and yet completely nerve-wracking. Even investing in an index, a constructed basket of shares and one of the fastest growing methods of accessing markets, the impact of a small number of constituent parts, i.e. companies, can affect the entire universe. This includes your pension and savings by the way.
More specifically, I am referring to an investment fund where the makeup of the index is determined by a concept known as Market Cap Weighting. These words may mean very little to the average investor, but they are probably the most important reason why pension and savings accounts have recovered their value in the 6 months since stock markets collapsed, and why the risk level inside indexes, usually considered the most diversified and therefore robust investment funds, has increased to levels not seen in decades.
EQUAL CAP WEIGHTING INVESTMENTS
To show how a Market Cap Weighting works it is best to first look at a simpler 'Equal Cap Weighted Index' first.
- Imagine a market has just 2 companies, A and B.
- Each company has 1,000 shares in the market and the share price is €1
- Each Company Market Cap (no. shares * share price) is €1,000
- The ‘Total Market Cap’ is €2,000, split 50/50 among the two shares.
An investment fund index that intends to replicate this market would obviously contain an equally weighted amount of shares from both companies. Any changes in price would be reflected in the fund on a pro-rata basis. For example, with a €100 investment, if the price of A goes up 10% to €1.10, your fund will increase by €5% because half your investment is in A
MARKET CAP WEIGHTING
The underlying mechanics of a Market Cap Weighted index are the same, but the strategy has on key difference.
- Assume the same companies and the same number of shares, 1,000, in each.
- This time, A is trading at €0.50 and B is trading at €1.50
- The ‘Total Market Cap’ is still €2,000, but now it is split €500/€1500 or 25%/75%between the two companies.
If we wanted to buy into this market with our €100, we can now choose two different strategies.
- Equal Weighted Fund: We spend €50 on 100 shares of AIB and €50 for 75 shares of BOI
- Market Cap Weighted Fund: We spend our money guided by the relative weighting, so €25 on 50 AIB shares and €75 on 50 BOI shares.
The difference in performance between an Equal Weighted and Market Cap Weighted fund, assume the EXACT SAME underlying share performance, could be as much as 50%, which demonstrates that often it’s not what you do, it's the way that you do it.....
MARKET CAP WEIGHTING IN YOUR FUND
Of course any sensible investor or fund will have far more than just 2 companies, meaning the impact of one company’s share price is much lower. One of the reasons that ‘index funds’ are so popular with investors and advisors is that they contain a huge number of different shares, with many of the Global Equity Portfolios we offer holding upwards of 10,000 companies!
The other benefit of Market Cap Weighting as a strategy is that it is the “truest” form of Passive Investing there is. In comparison to Active Investing, where some type of consideration or input from a fund manager is required, this approach is genuinely hands-off, as the market itself dictates how the investment fund is constructed and maintained.
Decades of data show us that Passive Investing outperforms all other strategies over time, and Market Cap Weighting is the best form of passive investing as well as being the easiest strategy to implement. While the media and entertainment industry would imply otherwise, people are actually really bad at picking winners and the less involvement we have the better!
MARKET CAP WEIGHTING IN 2020
Of course it wouldn’t be 2020 if there wasn’t something strange and unprecedented happening in investment markets, just to add to everything else we’re dealing with at the moment.
Usually, in broad terms, a stock-market will follow a collective & cohesive path, where stocks rise and fall together. Indeed, to avoid experiencing the full volatility of the equity journey, part of building a sensible investment portfolio requires incorporating other assets such as Fixed Income (Bonds), Property and Commodities (Oil, Gold etc.) to create the risk profile you need.
So, in March, when markets collapsed, pretty much every stock in the markets fell. That makes intuitive sense.
However, during THE RECOVERY we have seen since then, not all individual stocks have risen – far from it. In reality, a very small number of the huge tech companies have seen their prices jump, most likely on the basis of our extra reliance on them in a Covid-world, but due to their size, that increase in prices has lifted the entire market, index and personal investment funds.
REASONS TO BE POSITIVE
Initially it was feared that the recovery in markets was reactionary and without substance, attributed to everything from Government intervention (true) to a lack of sports on the TV (less so). However as the big tech firms have posted their earnings in recent months, we see that there are genuine reasons that they have become so valuable and there exists a solid commercial likelihood of it being maintained.
Indeed, as our world shifts to one with much more online engagement between people, depressing as that may be in real terms, these companies are likely to prosper even further, driving their own share price and the values of the markets & indexes that hold them to higher and higher levels.
REASONS TO BE WORRIED
‘Don’t put all your eggs in one basket’…..
As of August this year, the 5 biggest companies in the S&P 500 (the largest market/index in the world) have the same Market Capitalisation as the bottom 282, a situation not seen in decades and one that has often preceded a ‘major correction’ (euphemism for significant fall).
In case you wondered, those 282 'bottom feeders' are not some local small businesses, but some of the most recognisable brands in the world. That they are dwarfed in size by the likes of Facebook and Alphabet (parent company of Google) is not necessarily something to celebrate, as it shows a huge disconnect between ‘real economies’ and this new online universe.
For investors, it means that the increase in the value of their investments has corresponded, and is directly connected to, a significant reduction in the level of diversification in their funds, which increases risk levels. For most investors this has happened without their knowledge and for Fund Managers & Investment Firms, points to a real dilemma over what to do.
WHAT WILL HAPPEN?
As always, that’s the multi-trillion dollar question and, as of right now, there is no clear indication one way or the other.
When I speak to investors at times like this, I point to the 2 scenarios that would impact most – the outliers in terms of likelihood and outcome.
- De-risk or exit markets now and then miss out on continuous growth as the tech firms and/or the other companies in the indexes go from strength to strength.
- Stay in the markets and a major ‘correction’ occurs, wiping out the recovery and resetting the market back to a more diversified weighting, but reducing your own investment value at the same time.
An investors decision, ideally guided by their advisor, should consider their emotional response to both these hypothetical events, but also (perhaps more so) their circumstances. Those with time to invest can afford the risk/reward balance of scenario 2, accepting that, in time, the highs markets reach will become simply a benchmark for the average.
For those with less time however, the short term impact of real loss can be so profound that scenario 1 is the most prudent course of action.
For those of us who find ourselves working in markets and interested in sports, the intersect of the outlier remains a fascinating topic, where immediate sentiment runs against long term statistical normality. For me, I'll always remember that math class in 1987 when a dreadlocked dutchman helped me to learn about life in the mean and the potential of the outlier to lift us all up.