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Mutual Funds Report, Third Quarter 2015
Mutual Funds
The Ease of Index
Funds Comes With Risk
By
NORM ALSTER
OCT. 9, 2015
![](NYT%2020151011%20pricing1x40.png)
J.B. Hunt
Transport Services, one of the largest trucking companies in the
United States, trades at a much higher price relative to
earnings than its rival Swift Transportation.
KC McGinnis for The New York Times |
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.
![](NYT%2020151011%20pricing2x40.png)
J.B. Hunt is
listed on the S.&P. 500, and Swift is not.
KC McGinnis for The New
York Times |
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.
© 2015 The
New York Times Company |