When It Comes to Diversification, Don’t Be Naïve (Part 1)

The case for S&P 500.

Ben Johnson 15.12.2016
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Many attribute active stock-pickers’ collective struggles to best index funds to the overall level of efficiency of the market—particularly that for U.S. large-cap stocks. Efficiency in this case is meant to indicate the speed and precision with which market participants incorporate new information (economic news, earnings data, and so on) into stock prices (by selling on bad news, buying on good news). Furthermore, given advances in information technology and the growth in the portion of invest-able assets managed by an increasingly skilled set of professional investment managers, it can be argued the market has become ever-more efficient over time.

But market-cap-weighted indexes’ greatest strength can also be their greatest weakness. By owning “the market,” investors are relying on other market participants to price stocks on their behalf. During long stretches of time investors have done a good job of valuing stocks, but these long horizons have been marked by episodes of mania and panic. The mania most often cited as an example of the drawbacks of owning a cap-weighted index like the S&P 500 outright was the technology bubble. Episodes like this are unavoidable for index investors and create opportunities that have historically been exploited by (some) active managers.

Parting With Price
The concept of “breaking the link with price,” as Research Affiliates’ founder and chairman Rob Arnott would phrase it, when weighting stocks in an index surged in popularity following the bursting of the tech bubble. At the top of the tech craze in 2000, the sector represented about a third of the overall market capitalization of the S&P 500, as valuations for most stocks in the sector reached insane levels. As investors got up off the floor and began dusting themselves off after the crash, the asset manage- ment industry—as it so often does—mobilized to equip them with the weapons they’d need to fight the last war. In the case of exchange-traded funds, this resulted in a boom in new strategic-beta funds, with PowerShares and WisdomTree leading the charge. The common theme among most of these new funds was that the indexes they track do not weight their constituent stocks on the basis of their market cap, but rather some other fundamental measure of their worth, such as book value, cash flow, sales, dividends, or earnings.

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About Author

Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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