Why ETFs will now make weak companies weaker and strong companies stronger into April 2020

After the fastest falls from highs in the market’s history we’re now going to see dramatic changes in the quarterly re-balances of ETFs (exchange-traded funds) and portfolios.

Fisher & Paykel (FPH blue) vs the ASX Top 200 (XJO green) over the last 12 months:

These changes will make the strong stronger and the weak weaker. Here’s how:

How Indexes and ETF rules work:

1. Each quarter the market indices are updated by the index providers such as Standard & Poor’s, Moody’s and other index providers.

2. Many of the indices have rigid rules of what can and cannot be in the ETF portfolios. For example, the S&P ASX 200 holds the 200 largest companies on the ASX. When the smallest 200th companies gets overtaken by the 201st company they get swapped in and out.

3. The swapping of companies in and out only happens once a quarter.

4. Exchange Traded Funds (ETFs) follow the index and need to make the changes that the index makes. Not before and not a week or month later. It must be updated to follow the rules of the ETF.

5. The US market is now about 50% invested through ETFs, so when big changes like this occur, the ETF must follow the index like a lemming off a cliff.

6. An Active manager can pre-empt the move and profit from expected changes that the ETFs have to make.

As a result of the recent market falls, the ASX has an extreme example:

- Fisher & Pykel Health (FPH) is up +25.34% this quarter

- The ASX (or XJO) is down -28.83% over the same period

- FPH is currently a ‘small-cap’.

- FPH is now the largest small cap with a total value of $15,812m. The second largest small cap is currently Spark Infrastructure, half the size at $7,440m

- Moving up the scale, the next size index is the Mid-caps. The largest mid-cap is currently A2 Milk (A2M) at $11,788m

- FPH is now bigger than the biggest Mid-Cap share on the ASX.

- In fact FPH is now bigger than many blue chips such as: Brambles (BXB), Insurance Australia Group (IAG), Amcor (AMC), Suncorp Group (SUN), Scentre (SCG).

No one knows exactly what changes the index providers will make, however there is a reasonable assumption that FPH will be moved up the scales to a larger index.

How the Strong get Stronger:

Many portfolios, institutions and fund managers have mandates, or rules, just like an ETF. These rules might be that the portfolio can only hold small-caps and no blue-chips at all. Or the opposite, only blue chips can be held, not small caps.

We will see small cap portfolios forced to sell FPH.

We will then see large cap portfolios now allowed to buy FPH. These may be fund managers who are desperate to get a company that is growing in this environment, and FPH could be just the green spark in a portfolio of blood-red blue-chips that have been falling.

Finally there are ETFs. The largest ETFs in the world hold baskets of the largest companies. While FPH is not large on a world scale, there are many more ETFs that cover the top end of the ASX that will suddenly have to buy FPH – provided the changes we assume are going to happen, do happen.

How the Weak get Weaker:

The smallest companies on the indices that have performed poorly, will suddenly be dropped from the index.

As many portfolios have rules which state that they can only hold companies within an index, this will force further selling in the companies that have already performed poorly. This makes the worse performers even worse.