The largest stocks by market capitalization might be too big for their britches, and index funds could suffer as a result.
After several years of active managers warning about indexes like the S&P 500 containing rising concentrations in mega-cap stocks, the FANGs, an acronym for Facebook, Amazon, Netflix and Google, took a tumble in late July, dragging indices with them.
As the bull market ages, advisors and investors may want to consider alternative equity strategies that avoid or blunt the impact of volatility within the FANG stocks, money managers said.
“In market-cap weighting the S&P 500, the top 10 holdings are 22 percent of the weight, and the top 50 holdings have the same weighting as the bottom 450,” said Phil Bak, CEO of Ann Arbor, Mich.-based Exponential ETFs. “There’s a lot of concentration. It hasn’t really harmed investors seriously to date, but there may be a time where it does because there are people out there with indexes who have three, four or five percent of their assets in a single name.”
FANG stocks have become emblematic of the rise of behemoth technology stocks and their market leadership—so much so that new acronyms like FANMAG (which adds Apple and Microsoft to the FANGs) and indices like NYSE’s FANG+ (which adds Apple, Alibaba, Baidu, NVIDIA, Tesla and Twitter to an investible FANG index) have proliferated in recent months to encapsulate a unique, fast-growing and influential subsector of companies.
These FANG-like stocks led market gains through much of the current bull market, rising in value through mid-July. Thanks to FANG stock leadership, technology indexes have also run well ahead of the broader markets this year. Technology stocks were responsible for approximately two-thirds of the S&P 500’s return through the end of July, according to S&P Global.
“As of mid-year, Netflix had added about $80 billion of market cap, but the company’s revenue was only projected to grow by $4.5 billion,” said Todd Ahlsten, chief investment officer and portfolio manager at San Francisco-based Parnassus Investments. “That means you’re paying almost $20 for every dollar of revenue growth that a company like Netflix will generate this year. That’s a high price for growth.”
Investors have gradually become concerned about the influence the FANG stocks have on the rest of the market. In late June and early July, Oaktree Capital’s Howard Marks began raising the alarm on FANG stocks, arguing that investors had unrealistic expectations of the companies’ growth and revenue-producing abilities and that valuations had come too far, too fast. The charts of some valuation metrics, like the ratio of enterprise value to revenues, began to look parabolic.
After Facebook reported declining active users and missed revenue estimates in July, the stock dropped 20 percent—equivalent to $120 billion in market value—in one day. Poor second-quarter results from Netflix helped to compound the losses, leading to a broader technology sell-off, impacting mega-cap stocks like Apple, Facebook and Google. On July 30, the FANG+ index was in correction territory, down more than 10 percent from its June high-water mark.
“One of the biggest fears I would say regarding the FANGs, especially in the case of Facebook, would be long-term regulation,” said Ahlsten. “Facebook at one point was the disruptor. They were the first big mover in social media and during that time they had a very wide moat, grew cash flows and became a robust company. At some point that robustness has become more of a fragility. They still have a moat, but there are cracks and risks that the company can’t really manage.”