CityBusiness Guest Perspective
BridgeTower Media Newswires
NEW ORLEANS, LA -- Investing in the S&P 500 via a passive (capitalization-weighted index) product is a common strategy that is appealing to many investors. The low fee, low turnover, buy- and-hold dogma has many disciples evidenced in the fact that over a third of U.S. stocks are held in such strategies.
I argue that the cap-weighted investment methodology runs counter to how rational individuals, who typically desire to buy low and sell high, behave. I question whether the average investor understands the basic principles on which these portfolios are constructed and hope to illustrate in this article a few of the counter-intuitive aspects of such a strategy.
The first investable index fund was developed by Wells Fargo in 1970 and was equal-weighted, whereby the assets were evenly distributed among the stocks in the portfolio. The launch was during a time where stock trading costs were still regulated (expensive) and commissions could total 1-2 percent of the entire trade. In such an environment and having to bear the onus of quarterly re-balancing to ensure the various positions remained equal-weighted, the fund ultimately failed due to excessive trading costs. The more intuitive, equal-weighted approach of investing gave way to the more counter-intuitive market-capitalization weighted approach that is ubiquitous today.
In a cap-weighted index, when a given stock increases in price, it becomes a larger portion of the index as its capitalization rises. Cap-weighted index trackers are forced to purchase increasing amounts of the stock as its price rises when additional funds come into the strategy. Conversely, as individual stocks fall in price, these strategies purchase progressively fewer shares with new capital since these companies are losing capitalization on a relative basis.
By following such a protocol, cap-weighted investing is implicitly momentum based, buying more of what is going up in price (and potentially overvalued) and less of what is going down in price (and potentially undervalued). The allocation criteria is price alone, disregarding factors such as company profitability, growth, book value or any other fundamental factor.
Cap-weighted strategies in a sense do the opposite of what is logical when they are forced to buy high and sell low via index rules.
Despite limitations, disciples of the cap-weighted approach adhering to the Efficient Market Hypothesis believe that it is nearly impossible to beat the market on a consistent basis since the market price reflects all known information and is, therefore, fair value. In other words, they would rather let the market dictate the value of all securities in lieu of utilizing their own judgment.
Ironically, when investing in a cap-weighted strategy you are in fact betting that the winners keep winning and that the losers keep losing, rather than what has been illustrated over long periods of time - high flyers eventually come back to reality and undervalued stocks eventually rise (mean reversion).
I would argue that individuals of sound mind going about their daily lives would behave in the opposite manner. Does one walk into a store and largely disregard items offered on sale (good value) and divert their attention to what is overpriced? It is not rational to do so; and if one does, the motives are generally ulterior. For consumption, I believe we are disposed towards value, obtaining a good product or service at a favorable price.
Taking consumption out of the equation, and focusing strictly on investment, does it make sense to allocate the vast majority of your investable assets into what has already gone up in price? Cap-weighted indexes have no mechanism for selling what is most expensive from a valuation perspective in favor of what is of value because the criteria is price and price alone. Although there are certain examples in life where what is expensive is good, the wise would not always assume so.
I argue that investors would be more amenable to a methodology by which they invested in stocks that were overlooked; and, therefore, undervalued with the prospect of selling at a higher price at some point in the future. This approach seems to be more aligned with human nature and good sense rather than buying a disproportionate amount of what is already expensive, hoping the price continues to increase.
Due to the buy at any price momentum tilt of cap-weighted indexes, they are inherently prone to bloat, if not bubble. Currently the top 10 positions of S&P 500 (2 percent of the 505 stocks) account for 21.6 percent of the weighting, with the largest company, Apple, accounting for 4.4 percent of the entire index rather than .2 percent in an equal-weighted scenario.
Due to their affinity for capitalization, cap-weighted indexes strongly tilt large-cap, while equal-weighted portfolios in comparison allocate a higher share of the investment to small- and mid-cap companies.
Sector allocations are also prone to bloat. In the equal-weighted scheme, it is entirely based on the relative number of companies in each sector. However, for cap-weighted it is the size of the companies in the particular sector relative to those in the other sectors. Currently the information technology sector is 25.8 percent of the cap-weighted index while it accounts for 13.8 percent of the equal-weighted index. Utilities make up only 2.9 percent of the cap-weighted index while they are 6.3 percent of the equally weighted portfolio. The disproportionate share of information technology harkens back to the period before the dot-com blowup, when tech was 31.4 percent of the S&P. Following the rout, the sector fell to 12.9 percent of the index by September 2002. The financial sector was 22.6 percent of the index before the financial crisis, falling to 9.9 percent by February 2009.
I am not arguing that equal-weighted portfolios are always superior to their cap-weighted brethren, as small-caps generally fall more in a recession than large-cap companies. What is not often discussed is that the equal-weighted S&P portfolio has, over long periods of time, outperformed the cap-weighted index. We can attribute part of this outperformance to the increased exposure to small- and mid-cap companies. That said, I would argue that a more meaningful contribution to the outperformance is the systematic re-balancing of assets away from stocks climbing in price and into stocks falling in price (buy low/sell high) of the equal weighted portfolio.
Cap-weighted investing, due to its buy-and-hold mentality and low turnover, was born out of necessity in the high trading cost environment of the 1970s. As fees have compressed across the board from trading to advice, along with major advancements in technology and computing power, investors might be better served to invest in a more thoughtful methodology that does not disregard on a wholesale basis fundamentally driven valuations, declaring that only the market is the one true arbiter of proper value. We have seen repeatedly that the market tends to overshoot the mark with both excessive optimism as well as fear, creating investable opportunities to generate true alpha.
Some of the most talented money managers that have beaten the market consistently over the long term have done so by being significantly different than the cap-weighted benchmark. Yet, ironically, it remains the measuring stick by which we judge all investment results.
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Jean Paul Lagarde is portfolio manager and partner at Faubourg Private Wealth. All data sourced from Bloomberg. Securities offered through LPL Financial Member FINRA/SIPC. Investment advice offered through 360 Wealth Management LLC, a registered investment adviser. Faubourg Private Wealth LLC and 360 Wealth Management LLC are separate entities from LPL Financial.
