The Most Crowded Trade
“Indexing can't work well forever if almost everybody turns to it. But it will work all right for a long time.”
― Charlie Munger (1998)
“If everybody indexed, the only word you could use is chaos... The markets would fail.”
― John Bogle (2017)
A Crowded Trade
Markets have a tendency to go wherever they can do the most damage. That’s an old Wall Street adage that comes to mind whenever I notice too many investors sharing the same view. Consensus can be a good thing in science, but it's dangerous in markets. Over the span of my career, I have never seen a more crowded view than: "It is wise to invest in a market-cap weighted index."
Does This Make Sense?
Do you believe that Wal-Mart is 4x more compelling an investment than Target? If you owned an S&P 500 index fund, that’s the bet you’d be making. The index is weighted by the market size of each company. Since Wal-Mart is quadruple the size of Target, you’d own four-times as much of it in your index fund.
Do you think the outlook for Home Depot is twice as strong as for Lowe’s? Hope so, considering your index fund owns twice as much of it.
Is Exxon a better investment than First Solar? Maybe you think so. But is it 19x better? That’s the relative size of the bet you’d be making in your index fund.
Is Bigger Better?
Perhaps this weighting would make sense if larger companies outperform smaller ones. But that has not been the case. Historically, the largest companies in the S&P 500 have, in the aggregate, underperformed the other stocks after breaking into the index’s Top 10 ranks.
Naturally, these mega stocks outperform in the years leading up to this zenith, as indeed they have in recent years. Nvidia recently - and briefly - became the largest company in the S&P 500. It was the 12th company to attain this status in history. Looking at the other 11 companies that have reached this zenith in the past (including AT&T, DuPont, Exxon, GM, GE, IBM, and Phillip Morris), it is easy to be skeptical that past outperformance translates into future outperformance.
Yesterday’s winners have more often than not become tomorrow’s losers. Nevertheless, many believe that today's largest companies have more enduring competitive moats than their predecessors. Maybe. People used to believe the same about Wal-Mart, IBM, and Intel. But along came Amazon, Apple, and Nvidia. If you compare the list of top 10 S&P 500 constituents from twenty years ago with today's top 10, you'll note that only one has successfully remained a top company: Microsoft. And don't forget that even that company was losing its footing before Satya and ChatGPT came along.
Concentration
Index funds have gained substantial share from active managers over the past decade. This has resulted in flows into S&P 500 index funds that are then obligated to buy those 500 constituent stocks. Since the index is weighted by market size, the fund buys more of the largest and more expensive stocks. These fund inflows have driven increased concentration among the largest names. The ten largest stocks in the S&P 500 comprised 34% of the index as of May 31st, the highest month-end weight in decades. This is why Fielder has tried to avoid market-cap-weighted indexing for our clients where practical. We believe there are better ways to weight a portfolio, such as equal-weighting.
Impact on Markets
Steve Korn and I recently interviewed Mike Green, who has done eye-opening research into the the impact that index funds are having on markets. Important stuff. You can listen or watch here...
Yours in the Field,
Frank Byrd, CFA
IMPORTANT DISCLAIMER: This note is for educational purposes only. It is not a recommendation to invest in any particular security or strategy, since anything mentioned herein may be completely unsuitable for some investors. Speak with your financial adviser before investing. While the information presented herein is believed to be accurate, Fielder Capital Group LLC (Fielder) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in this email or any attachments. Fielder is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Fielder’s employees are not attorneys or accountants and do not provide legal, tax, or accounting advice. Financial planning and investment strategies have the potential for loss. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Fielder makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Investing involves risk, including the potential of complete loss of principal amount invested. Fielder offers no guarantees or promises of success. Nothing herein should be construed as a recommendation to buy or sell any securities. Fielder or its employees may have an economic interest in securities mentioned herein.
