The mainstream financial media is full of stories about the death of active investing, the end of the hedge fund industry as we know it and the explosion in popularity of exchange-traded funds (ETFs) like the SPDR S&P 500 ETF Trust (NYSE: SPY).
The basic rationale for passive investing goes like this: Mutual funds that track a market index, such as the S&P 500 and exchange-traded funds (ETFs) that follow similar indexing strategies, offer lower fees than actively managed funds, which employ legions of professional analysts and stock pickers.
Yet, few professional investors beat the market over the long haul, so why pay up for their management?
And while hedge funds were all the rage a decade ago, their 2 and 20 fee structure–2 percent of assets and 20 percent of profits charged for their services–is far higher than even the most expensive actively managed mutual funds. Plus, many hedge funds have struggled to produce superior returns over the past few years.
Many investors have bought into these arguments. According to the Investment Company Institute’s latest industry Factbook, US domestic index mutual funds and ETFs have seen total inflows of $1.4 trillion in net new cash and reinvested dividends between 2007 and 2016. That’s while actively managed funds have experienced outflows of $1.1 trillion.
Index equity funds now account for one quarter of all assets in domestic equity funds, up from less than 10 percent in 2001 and less than 15 percent as recently as 2010.
There’s little doubt this shift could, and probably will, continue in the short term. However, it has significant longer-term implications for the market and returns for individual stocks and sectors.
Consider that out of every $100 invested in the SPDR S&P 500 ETF, $14.63 is invested in the seven largest stocks. Around $31.33 of that $100 is invested in the ETF’s top 20 holdings. In contrast, just $9.39 goes to the 250 smallest components of the index. And the 400 smallest stocks receive only $33.82, about one third of the total investment.
Think about what this means for the market: As investors allocate more money to passive index strategies, most of that cash flows into the largest stocks in the S&P 500. These stocks, in turn, perform well and their importance to the overall index grows alongside market cap. The final step is that as even more cash flows into the index, these top-performing large caps benefit from even larger passive inflows.
Over time, the larger stocks in the index get bigger and bigger regardless of valuations and fundamental performance.
Consider that during the past three months, the S&P 500 is up around 3.57 percent including dividends reinvested. And just seven stocks in the index account for about 40 percent of those gains.
On average, these seven stocks trade at ratio of just over 31 times 2017 earnings estimates. As a whole, the S&P 500 trades at a relatively small 18.73 times earnings.
Particularly notable, online retail giant Amazon.com (NSDQ: AMZN) and graphics chipmaker NVIDIA (NSDQ: NVDA), trade at nosebleed valuations of 73 and 44 times forward earnings estimates, respectively. Together, they account for close to 12 percent of the S&P 500’s total return since mid-March.
None of this is to say that Amazon and NVIDIA aren’t good or even great American companies. However, it’s historically tough for a company–any company–to grow earnings fast enough to justify a multiple of 40 or 50 times earnings over the long haul.
Case in point: Few would argue that Intel (NSDQ: INTC) is a great company that dominated its industry back in March 2000 when it traded at just over 45 times forward earnings estimates. However, that doesn’t change the fact that 17 years later, at the end of March this year, an investment in Intel was still down 20.7 percent including dividends.
A great stock at an inflated valuation can be a terrible investment. We see particular cause for concern given the popularity of these ETFs and recent market developments.