Limiting Novo Nordisk to 10% of its index highlights the distortions created by passive investing strategies.

Passive Investing and the GLP-1 Weight Loss Boom

What does passive investing have to do with the GLP-1 weight loss craze sweeping the globe? Well, the Wall Street Journal reports the manufacturer of the blockbuster drugs Ozempic and Wegovy inadvertently highlights the distortions caused by a similarly popular phenomenon: index investing. Novo Nordisk, the maker of the these two treatments, recently became the most valuable company in Europe, taking the crown from LVMH, the luxury manufacturer of posh brands like Tiffany, Sophora, Louis Vuitton, and Christian Dior.

Novo Nordisk reached a market capitalization of $430 billion, while its home index of firms, the Nasdaq OMX Copenhagen 25 is valued at $750 billion. Since indices are constructed on float-adjusted market cap, Novo would comprise over half the index if included at face value. Indexing may involve trillions of zombie buying without regard to price or value, but hey, even index creators have limits. They are not about to put half their clients’ portfolios into one stock.

As a result of this and other European regulations, Novo Nordisk is limited to 10% of the index. This arbitrary limit has created forced selling in Novo stock, because indexes are required to sell shares of the company whenever its weighting reaches 10% of the index. Since demand is red-hot for Novo shares, this has not had an effect yet, but there is ample evidence that it could be once the weight loss drug craze loses some of its momentum.

As a precautionary example, German-American industrial gas company Linde went into great detail in a presentation on how index funds affected its stock price. The company actually relinquished its Germany stock listing in early 2023 because it was hurting shareholder returns. At an investor day in October 2022, Linde management showed that its stock had underperformed the market in 11 out of 12 cases when its weighting was above 10% of the local Dax index before the index was rebalanced each quarter. When it was below the 10% cap, the stock outperformed. Why? Because index funds had to sell to reduce the weighting when it was above 10% and buy to increase the weighting when it was above 10%.

Here is the slide from the Linde presentation:

 

As our friend Mike Green notes, the probability of the stock underperforming 11 out of 12 times by chance is 0.07%.

 

Linde ignored this effect until they had a big price decline in 2022. In a lesson for the U.S. stock market and the S&P 500, what happens when inflows wane, which is a real possibility if unemployment spikes in 2024 and 401(k) inflows become outflows.

 

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