The biggest consensus trade in modern history.
The legendary Jack Bogle revolutionized the investment management industry,most notably with respect to passive investing. One of Bogles legacies wasmaking such strategies broadly available to retirement plans, retail investorsand institutions at low cost. However, based on Principals investmentphilosophy and basic truths about long-term wealth creation, we stronglybelieve that investors should re-think their reliance on traditional capitalizationweightedindexes,1 particularly in US large caps, as we approach the later stagesof a prolonged equity market and economic cycle.
Passively replicating the S&P 500 Index has become the consensus trade,evidenced by the trillions of dollars in index ETFs and mutual funds. Lowercosts coupled with most fundamental managers underperformance have
really made passive indexing a no-brainer for institutional and retail investorsalike. Beta is enough is now a commonly accepted thesis to US large caps andseeking outperformance in other segments of global equities.
Like most things in life, cheap and easy isnt always best. While we are notpredicting a recession or a significant and prolonged equity market decline, themassive inflows into passive US large caps gives us pause. As with all trendsdriven by group-think and reduced risk awareness, the S&P 500 may eventuallybe in for a Minsky Moment if history is a guide. Coined after the economistHyman Minsky, this is defined as a sudden and major collapse of asset valuesfollowing a period of relative stability and risk-taking.
Behavioral economics tells us that investors experience gains and losses asymmetrically – the discomfort of a dollarlost exceeds the joy of a dollar gained.
The basic math of compounding also clearly illustrates this phenomenon. A10% loss requires an 11% gain to break even. A 50% loss needs a 100% gain; a 90% loss, a 900% gain. In volatilemarkets, especially sharply falling ones, passive capitalization-weighted indexes tend to be painful reminders of theimportance of seeking to mitigate downside risk and that simple beta is cheap – for a reason!
Overlooked risks of the S&P 500
Early advocates of smart/strategic beta argued that the S&P 500and other capitalization-weighted indexes are structurally flawed.Principals modern thinking redefines the market while challengingthe assertion that capitalization-weighted indexes are good enough.By definition, a capitalization-weighted index assigns increasingweights to companies that have appreciated in price and decreasingweights to companies that have depreciated in price, an investmentstrategy akin to buying high and selling low. The upshot is thatcapitalization-weighted indexes expose clients to both the upside anddownside periods of frothy valuations, as these indexes tend to chasebubbles up and get crushed on the way down, causing excessive and,in our view, unnecessary volatility.
Japan in the late 1980s is an extreme example of capitalization weighting gone wrong. Stocks
on the Nikkei had risen so high that they comprised nearly half of the entire global market index,
based on the expectation that Japan would continue to lead the world in technology. A decade
later, after the bubble burst and the ensuing Japanese market decline, the index weight had
shrunk to about 10% – a disastrous outcome for passive global equity investors. More recent burst
bubbles include the 1990s dot-com craze, the 2006 US housing crisis, and the 2017 shale oil
collapse, all of which amplified passive investor losses.
We believe this quote is particularly applicable to the massive pools ofassets that currently passively track the S&P 500. Convincing clientsof the merits of active management isnt easy in the face of strong
market performance.
Lets face it: who cares about a percent or two ofexcess return when the market is already providing double digits? That calculus shifts markedly, however,when returns are single digit or negative in later market stages. We believe our strong conviction in rethinkingpassive S&P 500 replication is both timely and supported by our intensive efforts in researching anddeveloping strategic beta and portfolio construction solutions for clients around the world.
In our view, an optimal US large-cap strategy participates on the upside and seeks to protect on the
downside, with reasonable fees and implementation costs, and no large, unintended concentrations of style
risk. In our work with clients, we have analyzed the S&P 500 and its downside risks at length in evaluating
low-cost strategic beta solutions for portfolio implementation. Our goal is to create options with a better
risk-return trade-off than the S&P 500 in the form of higher returns and/or lower volatility.
Isnt the S&P 500 too efficient to bother with active management?
Mega caps are the foundation for traditional capitalization-weighted large-cap indexes. For example, the top
50 stocks in the S&P 500 account for approximately 50% of its market capitalization. In our opinion, most
investors should own these 50 stocks in somewhat similar proportion to their capitalization weight. As the
most widely covered by analysts and other experts, they represent the most efficient part of the index where
it is most difficult to uncover differentiated insights to add value fundamentally. From an outperformance
standpoint, the remaining 450 companies and beyond has been where the action is.
The same market efficiency argument applies to smart beta. No style or technical factorswork consistently in this exclusive group of 50 companies. Indeed, the mega-cap universe accounts for roughly 85% of stock-specific risk in the entire S&P 500. Meaning, any factor tiltor stock picking in the bottom 450 stocks can be easily overwhelmed with a few wrong callsin the top 50 because this groups stock-specific attributes and risk profiles cannot be easilyreplicated. Apples and Amazons business models are relatively uniqueand mirroring their performance isnt as simple as owning other stockswith similar factor betas. Making big calls in this most efficient group,specifically being underweight in a few key stocks, explains much of theunderperformance by large-cap fundamental managers over the lastseveral years.
Mega caps have been like an exclusive neighborhood – they have beengenerally safer, less prone to decline during bouts of market and economicvolatility, and more liquid because of their desirable characteristics. In
our nearly two decades of applied factor research, weve learned that nocommon equity factor (e.g., momentum, value, growth) is consistently successful with thisgroup, with one notable exception: volatility. Lower volatility has provided a modest long-termreturn advantage over the S&P 500 mostly due to its focus on downside risk management.More so, it frees up investors overall risk budget for relatively inefficient asset classes andmarket segments where fundamental differentiation is more fruitful. In mega caps, less ismore, namely less volatility, while maintaining broad exposure across this special group.
Mega caps are compelling for investors focused on risk reduction
For risk-averse investors, we believe it advantageous to isolate these special 50 stocks rather than the entire
500. Replacing a capitalization-weighted S&P 500 investment with a top 50 mega-cap strategy, has historicallydelivered a comparable return profile to the S&P 500 with notably reduced downside risk. For many investors, thisalone may help improve long-term outcomes, understanding that this strategy will deviate from the S&P 500 instrong up markets but may catch up in down markets, seeking a better risk return trade-off over a market cycle.
A barbell approach with mega caps and small caps
Extending beyond the S&P 500, small caps may be an attractive solution for achieving a higher return profile.
Taking a barbell approach that combines lower volatility mega-cap stocks with higher volatility small caps may bea compelling way to outperform with an equivalent level of risk as the S&P 500.
While it is possible to use a passive index tracking strategy in this case, we believe it is suboptimal to do so, bothin terms of returns and risk. Small-cap indexes include many fundamentally distressed companies that long-terminvestors should avoid. Instead, we recommend a systematic or active approach depending on client preferences.A multi-factor small-cap strategy can work well without increasing the total risk profile of the portfolio. It allowsinvestors to tap into the long-term benefits of small caps and capture additional value through factor anomalies.As an example, a mix of the Nasdaq US Mega Cap Select Leaders Index and Nasdaq US Small Cap Select LeaderIndex has maximized returns with equivalent risk as the S&P 500.
Outperforming the S&P 500 with modern thinking and new tools
We have demonstrated that simple building block approaches can offer an exceptional alternative to buying theS&P 500. We believe we are in the maturing stages of the US equity market, where seeking to provide downside riskmanagement and adding value over market capitalization-weighted indexes will take on greater importance. Recallthat market capitalization-weighted indexing has a long history of disappointing investors when bubbles burst, andmarkets turn south.
The key is to create lower-volatility exposure to the 50 largest stocks and apply the remaining opportunity set to factorbasedexposures, thus mitigating against downside risk and/or seeking to earn higher returns without excess marketrisk. Factor-based investing and creative portfolio construction can add value to US equities investing. We believe acompelling alternative to buying an S&P 500 strategy is pursuing a barbell approach by combining the Principal Small-Cap and Mega-Cap Multi-Factor strategies. Although our example focuses on lower-cost strategic beta solutions, activefundamental managers can also be used to diversify portfolios and may help boost returns.
To view the white paper in its entirety, including all supports graphs and charts, please contact Nasdaqs Principal Global Equities Group
Mustafa Sagun isChief Investment Officer,Principal Global Equities at Nasdaq
