Saturday, May 06, 2017

Indexing Investment Strategy Becoming Increasingly More Risky?

Indexing ones investments has turned into the investment strategy of choice for a number of investors. According to a recent Wall Street Journal article, in 2016 82% of new investments coming through financial advisers (more than $400 billion) went into index funds and ETFs. This statistic was highlighted by Consuelo Mack on a recent WealthTrack segment where she interviewed David Winters of the Wintergreen Funds. Winters addresses several points about the potential risks and factors surrounding index funds, one risk called look through expenses and the other about index investing ignoring company fundamentals. I did not necessarily buy into the look through expense argument; however, the issue with indexing 'ignoring company fundamentals' is a very valid one. The WealthTrach video is provided at the end of the post.

First though, at our firm, we are an active manager and focus on two broad investment factors. One, the core of our investment strategy is constructing a mostly large cap individual stock portfolio around which we add exposure to other asset classes such as midcap equities, international equities, etc. We do utilize some index funds in a couple of asset class categories. Secondly, and equally important, we adjust a client's asset allocation mix between stocks, bonds and alternative investments according to their investment policy. This overweighting or underweighting of the various asset classes is as important as the investments we select. Our firm's recent decision to increase developed international exposure and add exposure to emerging markets in client accounts has been a positive one. Both of these foreign categories have been outperforming the S&P 500 Index since we made this decision in client portfolios.

So back to the WealthTrack interview. The issue around indexing ignores company fundamentals is an important fact for investors to be aware of. In looking at the popular S&P 500 Index fund, the dollars flowing into the index simply buy the stocks based on the market cap weighting of the stocks comprising the index. So, investment dollars flow into the largest companies in the index without regard to a particular company's fundamentals. Today, the five largest companies in the S&P 500 Index are technology stocks, Apple (AAPL), Alphabet (GOOGL), Microsft (MSFT), Amazon (AMZN) and Facebook (FB). Detail on these five stocks is shown in the below table.

All but Apple trade at a higher valuation than the overall index, yet may certainly be justified based on the earnings growth rate for each company. Importantly for investors though, an indexing strategy using the S&P 500 Index is becoming a more concentrated strategy, i.e., technology stocks are the five largest holdings. Also, indexing in the S&P 500 is looking more and more like a momentum strategy with these five stocks accounting for over 50% of the index's return this year.

In 2014 I wrote an article about the risk for investors that  fall prey to a consensus point of view. Indexing seems to fall into that category. In the post, I included a chart showing how a momentum strategy quickly turned into an underperforming one in a short period of time.

With indexing, and specifically the S&P 500 Index, its market cap approach to weighting its constituents, is pushing the strategy towards an ever more risky one in my mind. As is often the case, what runs up up in price often times falls prey to mean reversion. When the favorability of indexing ends, the end could certainly be less than rewarding to index investors. Below is the WealhTrack interview with David Winters.

Disclosure: Firm long AAPL, GOOGL, MSFT

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