Hidden Costs of Index Rebalancing

Introduction: Private Equity, IPOs, Price to Sales & the Passive Patsies Revisited
The Abundance of the Absurd in the World of Index Rebalancing
The Consequences of Expensive Additions
Conclusion
Exhibits
Appendix: Fundamentals of Expensive Additions

Introduction: Private Equity, IPOs, Price to Sales & the Passive Patsies Revisited

Starting in December 2018, Kailash published a series of interconnected research pieces tracking what we believe is unprecedented levels of group-think and the associated risks to investors. The papers most relevant to this research are listed below and document the following:

Private vs. Public Markets: Allocators’ record herding into private equity and the myriad investment challenges faced by the space
Better a Seller than a Buyer Be?: With public market valuations today equivalent to the 2000 peak this creates an appealing time for private equity firms to begin dumping their portfolio firms and possibly expose index investors to a good deal of risk
IPOs and the Passive Patsies: How the stratospheric valuations of firms being brought public by private equity today could damage unwitting index investors due to these firms’ long histories of generating ever larger losses
When the Top Decile is the Bottom of the Barrel: How the most expensive group of stocks based on Price to Sales (P/S) looked nearly as bad if not worse than any time in history and that subsequent outcomes in periods similar to today had been disastrous

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Kailash believes that the confluence of the above events and the simple mechanics of index rebalancing have rarely if ever been more dangerous for index investors.

Like private equity, index investing is benefitting from a frenzied bout of investor mania and Kailash believes investors in both would be wise to revisit their investments in these vehicles with a healthy dose of common sense.¹

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ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

SOURCES

Kailash is aware that some FTSE Russell indexes have blocked the addition of companies with less than 5% of voting rights in the hands of unrestricted shareholders. Kailash applauds these efforts but believes the same bankers who created the convoluted multi-class structures that afflict some of these firms may rapidly restructure them to conform to new index rules. This belief is founded on the fact that existing firms violating this rule will be given until 2022 to create conforming shareholder structures.

Disclaimer

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