Do you hold the majority of your investments in passive Vanguard funds? Yep – that sounds like me.
Almost no single stock picking? Sounds like me again.
Do you turn your back on active stock managers and primarily use index funds? I think we could be friends.
I’m sure you’ve heard the argument that investing in a total stock market index like the S&P500, VTSAX or equivalent provides a number of benefits such as;
- Diversifies your bets across many hundreds of different companies. If one of your stocks happens to blow up through poor performance, bad management or worse, then you have the others to rely on. It’s the investment equivalent of not putting all your eggs in one basket.
- The above argument even has some academic justification. You can talk loudly at parties about increasing your portfolio efficiency and moving to the “efficient frontier”. Any actuaries will instantly gravitate to your corner of the room, be in rapt attention, and offer to refill your glass and flag down tasty canapés for your delight.
- Passive investing diversifies your stock picks over the whole market and are in essence simply betting on the US economy as a whole (or whatever country you have biased in your portfolio). If the entire economy does well, if earnings rise steadily, if productivity increases and wages stay at a reasonable level then a rising tide will float all boats. The stock market will go up and the value of your funds will increase.
But is this actually true?
There are many different ways to construct a market index but the one that has become standard is to use an index that is weighted by the total market value of all the outstanding shares (“capitalization weighted”).
You might wonder why not weight each company’s contribution to the index by its stock price? Consider two companies, one with 100 shares priced at $10 each and another company with 10 shares priced at $100 each. Clearly these companies have the same value (same “capitalization”) and the fact that one company’s stock is trading at ten times the price of the other is not relevant.
The S&P500 is a good example of a US stock index that is weighted by the market value and comprises a broad selection of 500 of the largest companies in the US. It has become a good bellwether for the US economy as a whole.
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Beware the FANGs!
There have been some powerful forces at work in the US stock market recently.
Traditionally four stocks, Facebook, Amazon, Neflix, Google (now Alphabet) comprised the technology stocks collectively referred to as the FANG stocks, and they’ve seen some unbelievable growth. There are various flavors of FANG, and I’m going to look at including Microsoft and Apple in addition to the ones listed above.
See below Google’s performance (blue) against the S&P500 (red). Year to date, Google is up a staggering 26%.
There is no doubt that these FANG companies are large and they comprise around 13% of the S&P500, but they have had a remarkably big impact on stock markets returns this year.
Over the year to 9/30 around one third of the S&P500 performance was due to these six stocks!
Here is nice visual comparison. You can see that the FANGs comprise 13% of the index, but of the 14% return 4% was due to these stocks. Said another way, if the FANGs had been removed then the stock market would only have returned 10% and not 14%, year to 9/30.
The year to 10/31 this is even more pronounced, see the chart below.
The FANGs comprise 14% of the index at 10/31 but over 36% of the performance of the index over the year to 10/31. If the stock market had not included these stocks then performance would have been only around 11%.
Do you remember our argument for investing in index funds? Diversified stock selection, no single reliance on one company or one sector of the market? The returns represent an aggregate exposure to the US economy as a whole? I distinctly recall seeing you nodding along with me.
But the FANG phenomenon leaves a big stinking turd in the path of that parade.
It’s difficult to argue for an orderly diversification of returns when so few companies are driving over a third of the market performance this year. It’s also difficult to argue that the current growth in the US economy is driving these particular returns. By most measures the US economy is strong and growing, but why would that be reflected so strongly in so few companies? There are other forces driving these companies up.
Now, I’m not a perma-bear. I’m really not. But if you’re happy taking the good times then you need to be prepared to take the bad. And if these companies are so strong on the way up, they could certainly be equally forceful in their impact on the way down.
So What am I Going To Do?
Is there anything we can do to protect against the overbearing impact of the FANGs? Is there any way to protect ourselves against the disproportional impact they might have on the way down?
The obvious solution is to hold fewer FANG stocks. If you are committed to passive investing you could select an index that has a lower weighting to these companies. You could hold fewer large companies, such as the FANGS, and diversify into an index that captures more smaller or mid-sized companies. You could also diversify into international stocks, but you should be aware that does not solve the problem completely. Since the same phenomenon is currently being observed in international markets, where some Chinese and Korean technology firms are dominating returns. These companies are the BATS – Baidu, Alibaba, Tencent, and Samsung.
You could get fancy and invest in an index that weights the companies on other criteria to market capitalization. This is an area that gets pretty nerdy really fast. See for example this paper from Vanguard. I’m not sold on this aspect and there doesn’t seem to be a silver bullet here.
Other options include using active, and not passive, management. Why not outsource the decision as to whether to under-weight FANG stocks to a professional money manager? Whether this is a good decision relies on the money manager taking a view as to whether the FANG stocks are exhibiting bubble characteristics relative to other stocks and then taking less of a position in the FANGs. Depending on your attitude to active investing this could be a viable route. Personally, I see US large cap stocks as being a very hard index to beat. Very, very few managers have consistently added value relative the benchmark (less fees) in this space and I do not trust my ability to back the right horse.
But really this decision comes down to FOMO – Fear Of Missing Out. If you under-weight FANGs at this point then you are taking a bold decision and potentially hurting your future returns. Under-weighting the FANGs might benefit you in a downturn, but could very well hurt you in a continuing bull market. So if you have some kind of strong prescient view then by all means take a position, but for me, I simply don’t have an informational advantage over the collective set of US equity investors that are setting market pricing through their combined demand and supply. And I’ll be sitting on my hands and concentrating on the upcoming ski season.
What about you? Did you realize the FANG stocks have stuck their teeth quite so deep into the market? Are you nervous about the potential downside, and crucially, what are you going to do about it? Comment below and let me know.
Important notes. This blog post is not financial advice and we do not have an advisory relationship. This post is entertainment. For the avoidance of doubt I am the entertainer, and you are the entertainee. This post is to be read with the important notes.