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Crazy in ETF love? New study imagines bottling star quality

Crazy in ETF love? New study imagines bottling star quality

Identifying star power before it becomes self-evident is no easier in the investment business than in show business. Those tasked with finding tomorrow’s stars therefore have to rely on proxies, whether a dazzling smile or a killer app.

In both worlds, it’s important to distinguish genuine stars from those who merely possess some quality, which is far more readily apparent and so less valuable. The equivalent of a classically trained actor, for instance, could be a stock that qualifies for a quality index thanks to ‘strong and stable’ earnings.


But that, like theatre experience, implies reliability rather than true stardom. The MSCI World Sector Neutral Quality index contains Microsoft but not Facebook, for example, and Apple but not Amazon.

A new paper – by David Dorn of the University of Zurich, Lawrence Katz of Harvard University, and David Autor, Christina Patterson, and John Van Reenen of the Massachusetts Institute of Technology – offers an alternative way to define what they term ‘superstar’ companies. Their research is primarily concerned with labour’s falling share of GDP, which they argue can in part be attributed to these businesses.

‘We present a new “superstar firm” model of the labour share change,’ the academics explain. ‘The model is based on the idea that industries are increasingly characterised by a “winner takes most” feature where a small number of firms gain a very large share of the market.’

Although it is not the focus of the study, the prospect of owning these superstars will be of interest to investors. As examples of such firms, the authors cite obvious names including Google, Facebook, Apple, and Amazon, but also stocks that may not be expected like Wal-Mart and FedEx as well as unicorns such as Uber and Airbnb.

Shedding staff

What unites these firms? Autor et al point to a dominant market share by sales in the company’s industry, a low employee-to-revenue ratio, and a high patent intensity and total factor productivity. These metrics could form the basis of an index methodology and thus an ETF.

Some of the themes propelling these superstars to pre-eminence in their markets – the application of automation and artificial intelligence, for example – have already proven popular with investors, judging by flows into niche active and passive funds targeting these areas.

Looking at the superstars’ high present valuations, some may prefer to own their suppliers through artificial intelligence and automation portfolios. After all, those trends appear secular whereas superstars come and go.

Autor and co’s superstars may be different from the black holes of the past, though, benefiting from more defensive characteristics.

Digging moats

‘Firms initially gain high market shares by legitimately competing on the merits of their innovations or superior efficiency,’ the authors contend. ‘Once they have gained a commanding position, however, they use their market power to erect various barriers to entry to protect their position. Nothing in our analysis rules out this mechanism.’

The academics' findings come as just this week,  Renaud de Planta, chairman at Swiss active asset manager Pictet (which has recently soft closed a robotics fund) likened passive investments to antibiotics: 'Valuable when deployed in moderation, but likely to do more harm than good should their use become widespread.'

He reasoned the practice erodes competitive forces, because companies in the same sector end up with the same investor base.

However for investors following Autor and co’s labour share change model, the near-monopolistic nature of superstar firms could actually make them more defensive than traditional quality stocks.

That may provide some comfort to those hesitating while the superstars are flying at all-time highs.

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