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The trend to passive investing (investing in an index funds or ETFs based on an index such as the S&P 500) has accelerated dramatically in the last few years. Last year, American investors plowed a record $504.8 billion into passive funds, while pulling $264 billion out of actively managed funds focused on US companies. In addition, more than $100 billion in cash left actively managed hedge funds in 2016. The current trend started in 2006. It has been going on for a long time. It has been accelerating as the market recovered from the banking crisis.

The trend to passive investing is especially pronounced in the United States, where 18% ($4.8 trillion) of the industry's $27 trillion in equity assets are currently invested in passive funds, up from just 13% in 2008, according to data from market research firm Morningstar. Crucially, however, this statistic largely understates the real impact of index investing because it does not account for the impact of closet indexers.

Market Distortion

The S&P 500 index, currently the index that is the most frequent benchmark of the popular index funds, is a market cap-weighted index. For that reason, most of the money flowing into these indexes is being used, directly or indirectly, to purchase the stock of the largest 50 to 100 U.S. companies.

These purchases by the index funds channel money into these stocks because they are large, and because they are in the index, with no regard to the company’s intrinsic value or to future prospects. The market cap-weighting of the index also creates a feedback loop, as the flow of money into indexing becomes larger and larger, it distorts the value of publicly traded stocks.

Investment Opportunity

Value distortion in capital markets inevitably provides investment opportunities. So, it is worth some attention to what is going on at this time in the world equity markets. Economic demographics between now and 2030 argue strongly for a separation in the performance of the individual stocks within a particular index and also between indexes covering different sectors and geographic regions.

The projections below show that growth in Asia and other developing counties will overwhelm growth in the United States and Europe. Today many companies in the S&P have a strong presence in Asia, and can be considered world-class, but what is world-class scale today may look a lot different than world-class scale in 2030.

The long-term investor is best to direct his investments to those companies that will be world class in 2030. Some of those will be members of today’s popular indexes but the Asian markets will be key to world-class, and very competitive. As a result, many of the market leaders twelve years hence may not be represented in today’s popular indexes. For context, look back an equal amount of time and consider the position of the FANG stocks in 2006. Moreover, the rate of change in the next twelve years could dwarf that of the last twelve.

The leads to the prospect of widely divergent results in the future market values of the company’s in today’s popular indexes. Some of the companies in the S & P index will do well in the future and may eventually grow in to today’s price, but many will suffer from competitive pressure and be swallowed by the competition or become irrelevant. Many of these companies are overvalued in today’s market and will furnish very poor investment results going forward.

Middle Class growth (Market Demographics)

A study by Homi Kharas of the Brookings Institute estimates that the already burgeoning middle-class population in Asia will grow an additional 153%, from 1.4 billion to 3.5 billion that is increase of 2.1 billion people by 2030.

"In developed countries, middle-class consumption is about 44 percent of the global total, but averaging around $19,000 per person per year. Growth is essentially flat, at between 0.5 to 1 percent per year. In developing countries, consumption is growing far more rapidly at rates of around 6 to 10 percent per year, but from a much lower base of only $8,500 per person per year."
"The implications are stark. By 2022, the middle class could be consuming about $10 trillion more than in 2016; $8 trillion of this incremental spending will be in Asia … By 2030, global middle-class consumption could be $29 trillion more than in 2015 (Table 3). Only $1 trillion of that will come from more spending in advanced economies."

The United States had the largest middle-class market in the world ($4.7 trillion) but was likely overtaken by China (albeit in PPP terms) in 2016. The Indian middle-class market is growing fast and probably overtook Japan to move into third spot in 2016. By 2022, India could also overtake the U.S. and become the second-largest middle-class market in the world."

BAT vs FANG

Tencent, Alibaba, and Bidu are certainly overpriced based on current prices, on the other hand they appear almost cheap when compared to the FANG Stocks, and depending on how things turn out maybe a god part of the S&P 500.

Tencent is a large company whose current capitalization is roughly the same as Berkshire. Tencent’s earning are a little less than half of Berkshire’s but their growth rate is from a totally different universe, and these valuations may not be as outrageous as it appears at first glance
Tencent reported that their third quarter earnings jumped 61% over the same quarter last year. Revenue from Online games revenues grew by 48%, Social networks revenues increased by 56%, Revenues from our online advertising business increased by 48%, advertising revenue from social media increased by 63%, and Revenues from other businesses (primarily payment related and cloud services) increased by 143%.

The demographics offered are just estimates, but the implications are important to all investors and indicate that Tencent, the other BAT stocks, or whoever does eventually gain scale in these markets are sitting on the end of a very long runway.

Tencent has a lot of competition, and there are huge unknowns, but do you really want to depend on an index that does not include any part of this sector?

Investing for the next fifteen years

Going forward, the question may not be so much whether or not to index, but which index? Further, if you have chosen an index covering the economy that you want to invest in, or even a selection of indexes covering different economic sectors or geographical areas, is it passive investing, and is it really even indexing?

For more detail on this subject and lots of pretty charts see,

http://www.loschmanagement.com/content/third-quarter-letter-...
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