- Introduction: Index Funds are Eating Speculative Soup
- An Easy Win for Active Managers?
- But is Biotech so Different This Time?: Maybe Not!
- Conclusion: The Frightful Cost of Buying Scratch Tickets in Two Charts
- Appendix: Fundamentals
Introduction: Index Funds are Eating Speculative Soup
In the most recent paper Index Rebalancing and the Passive Patsies Kailash Concepts focused on the mechanical disadvantage inherent during index rebalancing due to its historical bias towards the addition of abnormally expensive firms. Kailash believes this has never been more relevant than today due to the elevated valuations of recent and potential additions approaching levels last seen at the peak of the dot com bubble. To summarize our prior work since December: passive investors may be ill served as a looming wall of exorbitantly priced unicorns may become eligible for index inclusion in the months and years ahead. As Kailash has shown in prior work,1 history has brutally punished index inclusions with these characteristics.
Having combed through the listing of recent additions to the R2500 index, not only were these additions trading at record P/S multiples but nearly half could not register a multiple due to an absence of revenues. This has led to an increase in overall index constituents with zero revenues as shown in Fig. 1 below. Since 2017 the percent of firms in the R2500 with zero revenues has more than doubled and is now at an all-time record. As the following research shows, regardless of the recent biotech sector bias, firms with zero revenues have historically offered investors dismal batting averages and terrible returns. It seems the primary appeal to these stocks is akin to buying a lottery ticket rather than an investment.
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