Mutual Funds Report, Third Quarter 2015

Mutual Funds

The Ease of Index Funds Comes With Risk

By NORM ALSTER  OCT. 9, 2015

The logic of investing in index funds has so far seemed simple and compelling for growing numbers of people.

Why spend the time researching individual securities and run the risk of choosing the wrong stock in the wrong sector when you can simply buy the market as a whole? Put your money in an exchange-traded fund, or E.T.F., or in a traditional mutual fund that passively tracks a stock index like the Standard & Poor’s 500 or the Russell 2000 and you have instant diversification without the risk of error in security analysis. The fees for such funds are typically very low, too. And E.T.F.s are traded all day, making for easy entry and exit.

But if you look closely at such funds, as several scholars and analysts have done, you may find that their simplicity harbors some simmering problems, which have grown more troubling in the course of the bull market in stocks.

Stocks in the Russell 2000 seem especially bloated in valuation when compared with non-index peers. S&P Capital IQ compared the valuation of stocks within that index to stocks of similar market capitalization that are not in the index. It used a common valuation metric, the ratio of stock price-to-book value. It found that the valuation gap between stocks in the index, and those outside it, had swollen enormously. That could make investing in the index a riskier proposition than is widely understood. 

Nonetheless, the popularity of index-tracking funds is unquestionable. They now account for over 30 percent of all stock and bond mutual fund and exchange-traded fund assets under management, according to Morningstar.

But cracks in the edifice of passive investing are beginning to show. While investing in index funds may still make a good deal of sense, it’s important to understand some of the funds’ pitfalls.

The August downturn, for example, featured multiple E.T.F. trading halts that suggested the funds are not easy to get out of in periods of high volatility. For the month as a whole, index stocks, especially those in the Russell 2000, also sold off a bit more sharply than non-index stocks, notes James Xiong, head of quantitative research at Morningstar. And both during and before the correction, index stocks moved together with a high enough correlation to call diversification claims into question.

Most disturbing, though, is the increasingly distorted levels of the valuations of some of the largest index funds. The combination of a long-toothed bull market and the significant shift to passive investing has indiscriminately buoyed all stocks in major indexes like the S.&P. 500 and the Russell 2000. Stocks that might not be bought singly on their own merits have been lifted by the package buying. Some portfolio managers, academics and market trackers now contend that the soaring of the mediocre alongside the exceptional has produced unusually elevated valuations.

The existence of a valuation premium for stocks newly included in index funds has long been known, of course. On average, from 1990 to 2005, when a stock was added to the S.&P. 500 — effectively requiring many investors to hold the stock for the first time — the mere inclusion added almost 9 percent to share prices, according to Jeffrey Wurgler, a professor of finance at New York University.

And it’s possible that, to some degree at least, stocks that are included in index funds are chosen precisely because their prospects are better and they deserve a higher valuation. In addition, another factor behind the current high valuations of stocks in the indexes is that investors have generally favored large-cap stocks in the current bull market, and the S.&P. 500 and Russell 2000 track such stocks.

Even so, current valuations for stocks in the S.&P. 500 and Russell 2000 have soared well beyond what might otherwise be expected, some analysts and portfolio managers say.

According to the calculations of S&P Capital IQ, non-Russell 2000 index stocks carry a median price-to-book value ratio of 1.34. But index stocks are accorded a 61.9 percent valuation premium at 2.16 price-to-book as of June 30. The premium has been in place each of the last 10 years but has been rising. In 2006, for example, it was just 12 percent.

“There’s no doubt in my mind that passive investing in E.T.F.s and index funds inflates the price of index stocks versus non-index stocks,” said Brian Frank, who manages the Frank Value mutual fund. “The whole market is overvalued,” he added. “Index stocks are more overvalued.”

Randall Morck, a business professor at the University of Alberta, has also concluded that stocks with the good fortune to be included in a major index receive premium valuation over those that are left out. Professor Morck is gathering data on current index valuations. He has tracked stock valuations through 2009. “It appears that the index premium rises as the market becomes more overvalued,” he said.

Professor Wurgler has also researched index premiums. “The evidence says that stock prices increasingly depend not just on fundamentals but also on the happenstance of index membership,” he said.

Passive investment vehicles, promoted for diversification benefits, also fall short of such claims. During the August downturn, the correlation in index stock movement spiked and was “very high” according to David Pope, managing director of quantitative research at S&P Capital IQ. Mr. Xiong of Morningstar says that index stocks — even apart from the correction — tend to move together. “We clearly see trading commonality,” Mr. Xiong said. With higher correlation, “diversification benefits decline,” he added.

The rise of passive investing in the current bull market has most distorted the valuation of small- and midcap stocks, some experts maintain. Frank Gannon, co-chief investment officer at Royce & Associates, says that every market cycle is dominated by specific and historically differentiated factors.

The two most significant factors in the current market cycle, he says, have been the Fed’s quantitative easing and the growth of passive investing. These have worked together to benefit weaker companies that are often laden with debt and bereft of earnings. Currently, roughly one-third of all the companies in the Russell 2000, are not earning any money, the highest percentage of non-earners in the history of the index, according to Mr. Gannon. So on one hand, quantitative easing has helped the weakest companies refinance debt at lower rates. On the other, passive investing has lifted the share prices of the weak along with the strong. “The growth of passive investing in the small-cap space has supported the non-earners in indexes like the Russell 2000,” Mr. Gannon said.

Asked to illustrate overvaluation with specific pairs of index and non-index stocks, Mr. Frank, the portfolio manger, cited Sovran Self Storage and Public Storage. Both are in the self-storage business, which has been flourishing. Public Storage, which is in the S.&P. 500, trades at a multiple of 36.9 times trailing 12-month earnings. Sovran, not in the index, trades at 31.7 times trailing earnings.

Premium index valuation is also illustrated by comparison of the freight haulers J.B. Hunt Transport Services and Swift Transportation, according to Mr. Frank. J.B. Hunt, which is in the S.&P. 500, trades at 20.6 times trailing 12-month earnings. Swift carries a multiple of just under 11. Price-to-book value for J.B. Hunt is at a ratio of 6.2 to 1. For Swift, it is just under 3.8 to 1.

David Blitzer, chairman of the index committee at S&P Dow Jones, said that index inclusion “raises the profile” of a company, which tends to increase valuations in several ways. Stock mutual funds and E.T.F.s held by long-term investors own about 12 percent of the shares of each stock in the S.&P. 500, he said. Inclusion therefore reduces the supply of available shares, putting upward pressure on price, he added. Another factor, he said, is that “an index is a good place to look for takeover candidates” for mergers and acquisitions, noting that “about 10 to 15 stocks within the S.&P. 500 are taken over each year.”

Investors who want to avoid exclusive exposure to the premium value stocks of the S.&P. 500 and Russell 2000 do have other choices. Vanguard, for example, offers the Total Stock Market E.T.F. which tracks a broader stock market universe — a total of 4,000 large-cap, midcap and microcap stocks in the CRSP US Total Market index. The Vanguard Total Stock Market mutual fund also tracks that index, which represents nearly all United States stocks and diversifies market exposure. Vanguard spokesmen did not respond to requests for comment.

Nobody can say for sure whether the premium valuation of stocks in the S.&P. 500 and Russell 2000 indexes will end with a bang or a whimper. Professor Wurgel notes that in the October 1987 market crash, stocks that were members of the big indexes dropped 7 percent more than non-index stocks. “I won’t be surprised if we see more of this sort of thing,” he added.

Of course, investors concerned about premium valuation and high correlation among S.&P. 500 and Russell 2000 stocks can opt for broader index-based funds, while investors of a more active bent may want to seek out non-index stocks that suffer in valuation comparisons with index peers.

So where is this all headed? We don’t really know.

Two academic researchers who collaborated on a study that found evidence of premium valuation for index stocks foresee differing consequences.

“I think index stocks would be hurt more in a deeper downturn,” said David Nanigian, associate professor of investments at the American College in Bryn Mawr, Pa.

But Michael Finke, a co-author of the study and a professor of personal financial planning at Texas Tech University, sees things playing out less dramatically.

More likely than a sharp sell-off in index stocks is the continuing popularity and even greater overvaluation of the group, he said. In time, Professor Finke suggests, index stocks will become ever more overvalued and that fact will finally be broadly recognized. The eventual result? “They will underperform,” he predicted, suggesting a shift by investors to non-index stocks.

Wise investors may still opt to choose index-based funds, but they should at least be aware of premium and diversification issues. And they should be careful about which indexes their funds are tracking.

A version of this article appears in print on October 11, 2015, on page BU11 of the New York edition with the headline: The Ease of Index Funds Comes With Risk.

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