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.
Passive Investing
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?
Market Indices
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%.
So What?
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.
FOMO
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.
Sometimes I like to make snarky super technical arguments just to get a rise out of people. For example:
“Solar energy isn’t really renewable.”
This statement is technically true, although everyone rolls their eyes when I make it. The sun’s energy comes from fusion which is a consumptive process, and it will eventually run out of fuel. The corollary (that fossil fuels actually do renew themselves over 100MY cycles) is equally annoying at cocktail parties.
This post reminds of one of my favorite finance blog troll topics:
“There is no such thing as purely passive investing.”
An index is a list of stocks. Someone has to pick which stocks go on the list and how they’re weighted. That isn’t passive.
And try as they might, so-called “passive” investors can’t invest in the “whole market”…what about OTC issues? Microcaps? There are lots of stocks that don’t get included in the various lists for whatever reason. Someone had to ACTIVELY decide to leave them out.
S&P decided that future companies who issue non-voting public shares (as $SNAP did) will not enjoy the benefit of being included in the S&P 500, but existing companies like $FB and $GOOG are grandfathered in for some reason. So S&P in all its wisdom has decided that certain types of governance structure should be ACTIVELY (and arbitrarily/inconsistently) excluded from its particular list of stocks.
On a related note, Saudi Aramco has vacillated on whether or not to go through with its record IPO (at least partially) because it looks like it might not get included in a lot of indexes if it leaves too much control in sovereign hands.
$GE is probably going to get kicked out of the DJIA…again.
I could go on, but I’ll stop there.
Personally I’m an investing agnostic that both believes in and rejects the efficient market hypothesis simultaneously. We have a lot of our investments tied up in low-cost, broad-market index funds, but I also actively manage a big chunk of it. Probably the perfect strategy to get the worst of both worlds. Oh well.
I think it’s pretty valuable to understand exactly what one is interested in, but I know a lot of people find it too boring/confusing/etc. to study it. I suspect a lot of indexers have no idea what they’re invested in.
It’s actually a pretty deep rabbit hole. Keep up the great content.
Hey – this got stuck in a spam folder – I’m really sorry about that.
I like your comment about believing and rejecting in the efficient market hypothesis simultaneously. I think I feel the same way. Although maybe I feel that some markets are more efficient than others. e.g. equities more efficient markets than bonds.
Fascinating topic. I’m going to argue the opposite. I’ve been studying the efficient frontier for a decade and I invest according to it’s tenets. I’m not a bogelhead and I don’t believe “picking” is irrational. I think blind picking is irrational, but statically directed picking is not. There was a system popular in the 90’s called “Dogs of the Dow”. It was a value based strategy that was based on reversion to the mean. Every year you invest in the 5 cheapest best yielding dow stocks. Since 2000 that DoD portfolio has yielded 8.6% per year. VTSAX is 7.9% (measured on a efficient frontier chart) half percent less.
1,000,000 invested for 20 years at 7.9% becomes $4.575M The same 1,000,000 invested for 20 years at 8.6% becomes $5.002M Note this is not active management, it is simply a form of rule based re-balancing, systematically no different than the guy who re balances 60:40 every year. This portfolio withstood both the 2000 crash AND the 2008 crash and beat the so called VSTX “diversified market vehicle” rather handily. You re-balance once a year and go skiing the rest. That extra $500K means you can afford to ski Zermatt instead of Alta.
I created 2 portfolios in the efficient frontier analyzer. One was the “set VTSAX, VBMFX” 60:40, a typical bogel portfolio. The other was to allow the analyzer to choose any of BRK.B, GOOG QQQ AMZN VTSAX VBMFX FB NFLX for the most efficient portfolio. The results:
60:40 gave me 7.41% return and SD (risk) 8.65% Not bad.
I ran the others but decided to leave off FB because its only been around 4 years and it wasn’t chosen anyway so it just added statistical distortion. The analyzer chose:
GOOG 5.15%
AMZN 4.8%
BRK.B 8.23%
VBMFX 81.83%
This portfolio gave 7.36% return with only 4.39% SD (risk) same return—2/3 the risk The analyzer could have chosen QQQ or VTSAX but it didn’t. So why would I fear the FANG? It looks like I should embrace the VBAG which is the variant of those stocks which is most efficient on a risk adjusted basis.
I played with other variants and sometimes VTSAX was chosen but it did not dominate.
If you look at this portfolio it’s A VERY CONSERVATIVE PORTFOLIO. It’s mostly bonds. It is correctly apportioned for max efficiency. I would rerun the analyzer every so often and re-balance according , to the analyzer recommendation, once gains became long termand after tax loss harvesting if needed. This portfolio traversed the 2008 downturn but not 2000 since google didn’t exist till 2005. I think why this works is because of creative destruction. GOOG AMNZ are clearly disruptive stocks. I think BRK.B is also which makes them efficient and stocks everyone wants to own.
I’m not dissing the bogelhead portfolio, but clearly the old “pile more and more on higher and higher” philosophy is not more diverse, because the risk is worse. It’s more likely a form of religion. I’ve presented 2 simple rational cheap to own reproducible non actively managed portfolios that re-balance once a year and beat bogelhead on either a return adjusted or risk adjusted basis. I present this for consideration not recommendation and a means of learning about fascinating “free money” of the efficient frontier. Hopefully an interesting discussion will result.
AoF You knew I couldn’t resist!
This is the analyzer I used https://www.portfoliovisualizer.com/efficient-frontier
Wow I am surprised at the VBAG portfolio, that a 20/80 portfolio can beat a 60/40 portfolio so comprehensively. I wonder whether the correlation assumption for those stocks is extremely low to bonds and so the optimizer is gravitating to it? Perhaps the correlation assumption of VTSAX with bonds is relatively high and so these individual stocks are being favored. I like it in principle but I’m still nervous about the idiosyncratic risk of individual stocks. Despite you seeming to demonstrate a lower vol.
Point taken on systematic strategies. Someone on twitter pointed out to me Dimensional Fund Advisers have a similar type of strategy.
I think maybe the point of this article was that by passive investing you have outsourced the decision rule, whereas you are taking ownership of that. Damn, if I’d been cleverer I would have made that point!
I Appreciate the echo-chamber disrupting comments!
I tested the correlation of VTSAX and VBMFX in the analyzer and they are correlated 1 : -0.11 which is what I would expect. I tested the correlations of VBAG
VBMFX 1.00
BRK.B 0.01
AMZN 0.01
GOOG -0.06
also what I would expect
Like I said I think these stocks are are related by disruption but otherwise uncorrelated. GOOG is a portfolio of disruptive technology businesses. AMZN which is often called a “tech” stock is NOT a tech stock it is a retail disrupter BRK.B is the best managed business portfolio on the planet, as opposed to something like GE or IBM.
I think your article explains what is going on. You claim 1/3 of the market gain in VTSAX is due to FANG. That means those are the important stocks. They are not represented however as 1/3 of the holding in VTSAX they are a smaller percentage. So VBAG is a synthetic of VTSAX using VBMFX as a much less risky bond based “everything else” as opposed to a stock based “everything else”. The efficient frontier analyzer will choose the set or subset of assets presented to it, in the correct ratios (this is IMPORTANT) to give you a tangent portfolio that has highest risk adjusted return compared to a risk free investment (T-Bill) So instead of risky chafe (stock based everything else) you are substituting very low risk “chafe” aka VBMFS. Since you are using the most frontier efficient arrow (VBAG) to propel your portfolio, you clean the inefficient bogelhead clock. This is why I call the bogelhead “diversity” religion. It is a PhD: pile higher and deeper, a mantra. The bogelhhead 3 and 4 portfolios are NO WHERE NEAR THE EFFICIENT FRONTIER and as near as I can tell are just so fever brained guesses in AA backed up by a bunch of testosterone on an internet list, which is not really different from just blind stock picking, or some broker calling you up with a hot tip.
I very much believe in using picking based in variance and co-variance and statistical optimization. It’s very much like stochiometry. Old time chemists figured out the exact ratios of chemical formula by mixing reactants in excess with one reactant that was limiting, and then calculated how things MUST correctly fit together
I use DFA funds in my passive portfolio index investing because they do provide some return advantage compared to straight Vanguard funds. They have a little bit more drag but far overcome that with return, not based on active management but based on statistical efficiency, like choosing to overweight small caps in a way that matches the efficient frontier.
When it comes to retirement investing
Rule 1 INVEST
Rule 2 INVEST EARLY
Rule 3 INVEST AS MUCH AS YOU CAN EARLY
It’s more the amount invested and length of time compounding that counts than the vehicle of investing. Any of the Bogelhead portfolio’s are more than adequate investment vehicles to achieve the goal, but there is a LOT of mythology mixed in to that scene.