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When market cap equals market pain

MANNIK DHILLON, CFA, CAIA 10-Oct-2018

While I’m usually the last person to claim one day’s performance means a whole lot, the dynamics of yesterday’s market pull-back made me think: Could this be a glimpse of what lies ahead for some passive investors if, and when, we enter a full-blown correction or prolonged period of market turmoil?


While investment strategies that weight stocks based on market cap size may be a great way to measure where capital has been allocated, I’ve long held the belief that it may not be the best investment solution for everyone. They lack the diversification we long for in the investing world and this approach flies in the face of what we worry about most: risk.  

Consider these stats from yesterday’s market activity (October 10, 2018): 


S&P 500 Index: -3.29%

S&P 400 Mid Cap Index: -2.63%

Russell 2000 Index: -2.86%

Russell Top 50 Mega Cap: -3.62%

Nasdaq Composite Index: -4.08%

Nasdaq Victory US 500 Vol Wtd Index: -2.75%

Facebook, Apple, Amazon, Netflix, Google & Microsoft provided 26% of the S&P 500’s decline

The top 10 stocks in the S&P 500 provided 30% of the decline while the top 50 accounted for 56% of the decline


Dissecting the returns of yesterday by market cap was an alarming exercise. The ultra, mega cap companies that advertised to fare better in a stark downturn than mid and small caps didn’t behave as expected. Why?


I looked further to uncover where the pain was concentrated. Not a surprise, the tech sector got routed in yesterday’s interest rate-driven sell off. Specifically, the tech sector alone accounted for 37% of yesterday’s decline. This makes sense, I suppose, as many of the mega cap names are also tech companies, much like in the late 90s. Looking at yesterday’s activity at the individual stock level (Netflix: -8.4%, Amazon: -6.2%, and Apple: -4.6%), I was reminded of a Mark Twain quote, “History doesn’t repeat itself, but it often rhymes.”


While today’s tech sector is different from that of the late 90s, its pent-up momentum, a pervasive bet on growth, and precipitous run-up in many of these mega caps makes for a fragile segment of the market. 


So, what’s the best course of action for investors? While there’s no single right answer, having a strategic plan and sticking to it is likely the best course of action over the long term. 


Strategies that seek to track the performance of volatility or risk-weighted indexes, such as the Nasdaq Victory US 500 Volatility Weighted Index (NQVWLCT) are designed to help investors prepare for when true diversification benefits are most precious: when things get rocky. 


Minimum volatility approaches that seek to track indexes such as the Nasdaq Victory Multi-Factor Minimum Volatility Index (NQVMVUS) can also be good diversifiers. And, minimum volatility strategies that include a multi-factor front end may also help to keep better pace on the upside while markets stay frothy. 


Finally, for those worried about rising rates and a slowdown in global growth initiating a sell-off that leads to a bear market, having a predetermined plan to reduce equity exposure, such as a strategy designed to track the Nasdaq Victory US 500 Large Cap 500 Long/Cash Volatility Weighted Index (NQVWLCCT), may provide some peace of mind.