In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at the weaknesses of market cap weighted indices are constructed and why selecting stocks based on fundamentals may be a better approach for long-term investors. An excerpt is below. To subscribe to the Validea Hot List, click here.
“Many index funds may not quite be the great diversification tools that they appear to be, even though they may hold hundreds or thousands of stocks. Take the 5 largest stock index funds, which combined have more than $675 billion in assets under management. Three are 500-stock funds that resemble the S&P 500, while the other two have about 3,000 stocks each. All of them have the same top 10 holdings, according to data from MarketWatch and Morningstar. And, on average, those 10 stocks make up 15.5% of the 5 funds’ holdings. An investor who puts a chunk of his or her portfolio into one of those index funds because they do not feel confident making big bets on individual stocks thus ends up making some pretty big bets on individual stocks — often without realizing it.
In fact, if you take a look at the holdings of the biggest index funds in terms of assets — it’s one that tracks the S&P 500 — you get an idea of how much of an impact the “big guys” have on market-weighted indices. The 255 lowest weighted stocks in that index have portfolio weightings ranging from 0.1% to 0.01%. Combined, those 255 stocks make up a little over 14% of the portfolio — less than the 14.6% of the portfolio that is taken up by just the 8 most heavily weighted stocks. (Fund information comes from ETF.com.)
Perhaps you’re thinking that the big guys should be weighted more heavily. Many S&P index fund investors are looking to get representative slice of the US economy, and a company like Apple obviously makes up a much bigger portion of the economy than a company like Diamond Offshore Drilling, which is tied for the lowest weight in the index with a weight of 0.01%. That’s true. But even considering that, the index is tilted much more heavily toward the big guys than you would think. While it had about 100 times as much in 2014 earnings and about 85 times as much in trailing 12-month sales as Diamond, Apple is weighted 368 times more heavily than the offshore drilling company in the index. Now, in this particular case, I happen to think that Apple is a better stock than Diamond — the tech giant has had a spot in the Hot List at various times this year. But that won’t always be the case, and the nature of a market-weighted index fund creates a situation where you can be making a big bet on a bad stock.
In addition, I think the prevalence of S&P 500-tracking index funds may well be opening up long-term opportunities for fundamental investment strategies like the Hot List. Historically, smaller stocks have had a long history of outperformance, as I have often noted here, with one big reason being that they are less visible and less followed than bigger stocks. That means you can find some great small stocks flying under the radar. Now, with so many people piling into index funds that heavily weight the biggest firms, the small stock under-the-radar advantage should be even greater. That’s because as more and more money goes into these large stocks via index funds, many may become more highly valued than their fundamentals merit — index fund investors aren’t looking at the valuation of every one of the index’s holdings before they buy the fund.
Smaller stocks not in the big index funds, conversely, could become even more overlooked than usual, creating big-time bargains in that space. Investors who focus on fundamentals and are willing to invest in smaller stocks should thus be able to reap the benefits over the long term. And smaller, lesser-known stocks that are not in the S&P are the types of companies that the Hot List usually keys on. If you remember, I’ve written previously about the portfolio’s high “active share”, which is a measure of how much a portfolio differs from the index it tracks. Research has shown that portfolios with high active share tend to have a better chance of beating the index. The Hot List often has very few holdings that are members of its benchmark, the S&P 500; prior to today’s rebalancing, just one of its stocks (Apple) was a member of the index. Rather than going after those large stocks that everyone knows about and which are part of the major indices, the portfolio goes into areas of the market that get less attention, where mispricings of quality stocks are more likely to occur.
All of this isn’t to say that you should avoid index funds. I’m not even saying that you should avoid market-weighted index funds. For some investors, a market-weighted index fund may be a great fit for a portion of their portfolio. But the point here is that you need to really know what you are investing in, and how it works. During difficult times, like those we’ve seen in the past month, it can be tempting to throw up your hands, forgo stock-picking altogether and pile into an index fund. But if you don’t know what you’re getting into, you could find yourself with some unexpected problems — and you could miss out on a lot of excellent opportunities.”