Many portfolio managers whom others call "value managers" are really closet indexers, more concerned with standard deviation than with absolute returns. So suggested Christopher Browne of Tweedy Browne Global Value Fund when he addressed next-gen money managers at Columbia Business School in New York last November on the subject of "Value Investing and Behavioral Finance."
Browne went on to explain that sticking close to the index is actually rational behavior on the part of a money manager who hopes to receive assignments from pension funds and other long-lived asset pools. These sorts of institutions typically make manager selections based on style categories and degrees of deviation from certain benchmarks or indexes. The result is that hundreds of so-called active managers end up riding herd on a list of stocks very similar to the index against which they are measured, and they struggle to add enough value at the margin to
a) overcome the fee drag and
b) have enough left over to look relatively good. Being down less than the index now is as good as beating it during a bull market.
Forget Alpha And Beta
I don't know about your clients, but the retired investors who look to me for guidance, even if they have some familiarity with "style drift" or "standard deviation," care little about either. What they want is worry-free returns that, over time, are greater than risk-free returns from government securities or bank deposits. They want real, spendable returns on their investments. If we don't deliver that, they'll find little solace in learning that, "The market has been lousy for three years," or "Our fund managers didn't deviate from their style, but it was out of favor," or "You lost less than the market," or "Your beta was low and your alpha was high." No, my clients have made it very clear to me that they can't spend relative returns.
Which brings me to the point about index investing. I have become something of an expert on the reasons that retirees are attracted to S&P 500 Index funds. They understand that such a fund is "a cross section of American enterprise," that it is an unmanaged portfolio that routinely provides higher returns than most active managers because it has lower operating expenses and is always fully invested. Furthermore, they say, an S&P 500 Index fund rarely makes distributions to shareholders, so it is tax efficient. And did I mention that the index returned an average of 14% a year for the last 25 years and more than 19% a year during the 1990s? What's not to love?
Beyond understanding why people are attracted to index investing, I am not an expert on the indexing phenomenon in any academic sense. However, from a purely practical point of view, several things occur to me that could make a 500-index investment considerably less productive over the next few years than folks have come to expect.
Not Really Diversified
For openers, the S&P 500 Index is not really "a cross section of American enterprise" in the sense that many investors believe it is. For example, it includes just 500 stocks, which represent about 7% of the approximately 7,000 publicly owned and traded American companies. It only includes large companies, typically the largest players in various broad industry categories. Yet it is regularly referred to as "the market" by both finance professors and talking heads. So, if you want to own the "500," treat it as a large-cap growth fund, not as a diversified portfolio.
Even as a large-cap growth portfolio, I have some concerns. Because the S&P 500 is a market-value-weighted, or cap-weighted index, an investment in an index clone fund will be highly concentrated in a few of these large companies. The largest 5% of the 500 companies, that is just 25 stocks, recently accounted for about 40% of the money invested in an S&P index fund. Ten stocks accounted for 25%.
For example, General Electric has the largest capitalization in the index, weighing in at $471 billion. The smallest cap in the index is McDermott International at just $648 million. Hence, if you invest $50,000 in an S&P 500 Index fund, you would be investing $2,140 of it in GE and only $2.94 in the smallest company. A ratio of 728-to-1. Please, somebody explain to me why I would ever invest 700 times more in one stock than another simply because it has a larger market cap!
Buy High, Sell Low!
Typically, a company's capitalization has vaulted to the highest decile by a combination of growing its business and being accorded a high P/E ratio by an adoring public with a rose-colored view of its future. Hence, it seems to me, almost by definition, an investor in a cap-weighted index is placing his greatest bets (the gambling terminology may be not wholly inappropriate) on stocks that recently have been most popular and the smallest wagers on those that are unloved or undiscovered. But didn't the richest investor in America teach us that investors do best by buying stocks when nobody else wants them? Hmmm.
As a stock's price rises, it has increasing influence on the value of a cap-weighted index. Thus, a mutual fund imitating the S&P 500 Index will exhibit outstanding performance during a long bull market in large-cap stocks. From 1982 to early 2000, many large-cap stocks, particularly technology and communications stocks, gained in price faster than their companies' earnings grew.
Optimistic market commentators suggest that the U.S. "market" deserves a higher P/E ratio than its long financial history would indicate is "normal" because the explosion of technological innovation is driving up the economy's growth rate. It is hard to think of a decade with a more exciting parade of new technologies than the 1990s, yet the growth rate of corporate earnings was only slightly better than the average growth since 1960. The S&P 500 Index value, on the other hand, rose more than twice as fast in the nineties as its average annual increase for the last four decades.
And I should note that net profit margins in 1990 were nothing to write home about at 4.5% (Value Line Industrial Composite). The 7.3% earnings growth of the '90s included the benefits of an economic recovery that boosted profit margins to 6.4%, the upper end of their historic cyclical range. Of course, the double-digit plunge in profits this year demonstrates that the margin improvement was not a jump to a new, permanent plateau. It seems clear, then, that earnings growth does not provide a satisfactory explanation for the P/E expansion among large-cap stocks in the 1990s. A more sensible explanation, it seems to me, is that it reflects the self-reinforcing optimism of a naive investor class.
Choose Your Mantra
When we advisors look at a class of assets, such as large-cap growth stocks, and note that it is very expensive in historical terms, we have a choice to make. We can either repeat the mantra, "Over long periods of time, stocks earn more than bonds" and keep our usual allocation to that asset class. Or, we can elect to reduce or even eliminate that asset class from our portfolios in favor of another that represents a better investment value. If you manage a university endowment, you may be attracted to the mantra for the sake of job security. Since I manage retirement portfolios for real people, my strong instinct is to forget the mantra and go for the value. After all, five years can seem a very long time to a retiree when markets are regressing.
OK, you might say, I could trim the large-cap allocation, but I can't imagine eliminating it. What if they get popular again? There is always that possibility; just because something is expensive doesn't mean it can't get more expensive. But it is worth considering what the risk is if instead of a return of the bubble, we should get a reversion to mean.
If the 25 largest stocks in the 500 index have outsized influence on the upside in a bull market, wouldn't they exert similar power to the downside when and if they lose their aura? Of course they would. Think of it this way. What would happen to a dollar invested in the S&P 500 Index for the next 10 years if earnings grew a normal 7% a year and the index P/E ratio dropped from 23 times earnings to its long-time average of 14x? You are not going to like this ... the answer is that the dollar becomes $1.19 (that's in 10 years, not inflation adjusted) for a whopping annual return of 1.8%. If the reversion to a 14 P/E ratio should happen over just five years while earnings grow the average 7% a year, the dollar invested in the large-cap index would shrink to 85 cents!
Dare I mention that market corrections have a habit of not stopping at rational, long-term average valuations? Rather, investor discouragement tends to reinforce itself much as enthusiasm does, taking stock price to the other irrational extreme. If this possibility troubles me (which it does!), just imagine how it looks to a retiree who will be withdrawing money from his or her portfolio during each of those years.
The ABC Solution
What can be done about this apparent overvaluation? Well, what the more optimistic investment strategists seem to be doing is assuming faster-than-historical future earnings growth because this justifies maintaining or increasing the P/E ratio. Because I see no evidence in the macro data to support this faster growth assumption, I am not comfortable with this solution to the valuation problem. I am more inclined to adopt a strategy that a) increases the fixed-income content of my portfolios (especially since I remain an optimist on inflation), b) underweights or avoids the large-cap growth sector, especially the cap-weighted S&P 500 Index and c) emphasizes small-cap and value strategies in my equity selections.
You might correctly protest that over 30 years, a low-cost index fund would earn a 41% higher return than an "actively managed" mutual fund with identical investments and a 1.4% fee ... just because of the fee. That is true. So when I suggest moving away from the 500 index toward actively managed mutual funds, it is important to emphasize that I do not mean actively managed funds that are managed by those "closet indexers" to whom Christopher Browne alludes. I want to invest with fund managers who make their biggest investments in their best ideas. I want research-based funds with the courage to exploit market inefficiencies and ignore what everybody else owns. Everyone loves "average" when it is 19% a year, but if average becomes 1.8% a year for a while, it is not going to do my clients any good.
Just One More Thing
I love it when detective Columbo, about to shuffle out the door, whirls around in his shabby raincoat and mumbles, "Oh, there's just one more thing ..." He usually does this two or three times in succession, and I chuckle every time. Well, there are two more observations I need to make about index funds. First, it is really not correct to call them "unmanaged." Standard & Poor's actually has a standing committee responsible for keeping the 500 names fresh. The same committee decides what portion of the index is to be represented by this or that industry grouping. These are very influential decisions. So I would be comfortable calling it a low-turnover portfolio, but not "unmanaged."
In 2000 alone, there were 58 company changes in the 500 Index. The names added last year included Veritas Software ($37 at the end of July, down from $160 last October), Siebel Systems ($33, from $110), JDS Uniphase ($9, from $100) and Palm ($5, from $60). Like any active manager, this committee's stock picks often go awry.
Finally, there is the matter of tax efficiency. Turnover in a portfolio causes capital gains to be realized, and mutual funds have to distribute them; to their advantage, S&P 500 clone funds have had pretty low turnover. They also have enjoyed very strong inflows of new cash for years; the Vanguard 500 grew from $9 billion in assets in 1994 to about $100 billion last year. New money allows the fund to perform its routine rebalancing with little or no selling. But what if investor money starts to flow out? What if index funds begin to suffer redemptions? They don't carry cash reserves, so redemptions will mean net sales, which may well unleash all those pent-up unrealized capital gains.
I conclude that the 500 index has seen its best days. It is now a widely owned, passively managed, low turnover, concentrated, overvalued large-cap portfolio that could become a tax trap even as its returns regress painfully to the long-term mean. Am I afraid to not own this? I am not!
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.