Narrow Stock Market Returns Spell Danger for Investors
December 7, 2015, 5:59 pm

This year, the stock market has had a bad case of the narrows — the narrowing of great returns to just a few stocks. This has been one of the rare years when nearly all the returns in the market can be traced to just a handful of companies.

While investors have enjoyed outsized returns from these high-fliers, their stellar performance is all that’s propping up many mutual funds. Many investors, especially those who own large-company index funds, may not be aware of the risk this creates.

Among the stars driving the market this year are Amazon, General Electric, Alphabet (aka Google), Microsoft and Facebook, which have accounted for nearly all of the gains in the S&P 500 index. As investors pour more and more money into securities tied to indexes like the S&P, their returns on this investment have come from a smaller and smaller subset of stocks. By comparison, 2013 and 2014 saw the 10 largest stocks account for less than 20 percent of the year’s S&P 500 growth.

What does this year’s narrowing mean for investors? In the dozen or so times that narrowing has occurred in the last 30 years, it has often preceded a downtrend in the stock market. This time around, some Wall Street pundits see this narrowing as a sign that the bull market may be about to end.

These pundits may be right, but I have another view. The market bull may not be finished running, but regardless of whether this happens in the coming months, we may be entering a period when active mutual fund managers -- who choose stocks for their funds rather than trying to match the returns of an index -- are poised to beat index funds, which are passive investments whose holdings reflect a given index and thus require no real management. This would be a reversal of a long-running active-versus-passive scenario over the past 15 years, where investors have flocked to index funds and four out of five active managers have failed to beat their benchmarks.

One reason for the superior overall performance of index funds is lower costs. It’s much cheaper to maintain an index fund than to research and choose individual stocks. But those who joined the stampede to index funds may be surprised to learn that active managers actually play an important role, especially in times of market turbulence.

During the 2008-2009 market meltdown, active funds outperformed indexes. That’s because active managers can react quickly when markets swoon, providing at least some downside protection, while passive investors are fully exposed. Active funds can move into defensive positions while index fund investors must grin and bear it, staying the course and chanting the industry mantra about how passive investing delivers better long-term average returns. Of course, the question for many investors is: Does the timing of your retirement coincide with these long-term averages, or will a solid hit to your portfolio inconveniently come just before you retire?

As stocks like Amazon and Facebook surge to high valuations, active managers can take profits and pass them on to mutual fund shareholders, ensuring that these star stocks don’t become too big a factor in their funds. Yet with index funds, such stocks can become too big a factor, pumping up returns while creating vulnerability because of an over-reliance on these stars to produce returns. When these stars dim, the entire index fund may falter.

Investors should consider taking some money off the table during this narrowing of the market and perhaps redirecting it to active management. If you own individual stocks, here are some ways to adjust your holdings:

Sell some shares of Facebook (FB), P/E 50, buy homebuilder DH Horton (DHI), P/E 13. People can’t just live on Facebook; they also need an actual home.

Sell some Amazon (AMZN), P/E 355, and buy some Nordstrom (JWN), P/E 17. People still want to try on shoes and feel high-end clothes before they buy. Online shopping isn’t suitable for all items.

Sell some Netflix (NFLX), P/E 620, buy some Comcast (CMCSA), P/E 18. Comcast is likely what comes up when you turn on your TV; you don’t have to log in to find it.

Sell some Alphabet (GOOG), P/E 27, buy some Cisco (CSCO), P/E 12. Google isn’t terribly overpriced, and Cisco is relatively is old school, but you need Cisco products to get to Google.

Investors who want to stick with indexing should look at how their index investments are structured. Indexes like the S&P 500 are capitalization-weighted. This means that the companies with the largest market capitalizations (the total value of shares outstanding) have an outsized impact on the S&P 500 index. For example, Apple represents 3.71 percent of the index. And the top 10 stocks in this index make up 17.6 percent of its total assets. By comparison, many companies at the bottom of the S&P 500, with low market caps, together comprise just a tiny fraction of one percent of the value of the index.

This is why owning equally weighted index funds can reduce your exposure to high-flying companies that have dominated the S&P 500 index. For example, in the past year, the market-cap-weighted S&P 500 index fund SPY rose 1.16 percent through Nov. 30. During this same period, index fund RSP, which is equally weighted instead of market-cap-weighted, fell 1.61 percent. But over the past six years, SPY rose 85 percent and RSP advanced 125 percent. Thus, RSP investors did better because of this fund’s equal weighting. If you own shares of a traditional index fund such as the SPY, it may be a good idea to swap some shares for an equal-dollar-weighted fund like RSP.

Another protective measure is to add some actively managed funds to your portfolio. But investors need to understand that periods of underperformance from active management are inevitable. A study by Davis Funds found that from Jan. 1, 2004 to Dec. 31, 2013, 95 percent of the top-performing active fund managers had underperformed the market at least once in a three-year period. You can’t have blissful highs without some dark lows, but as with any investment, it’s the long-term averages that count.

The bottom line for any investor is to have diversification -- the more eggs you have in your basket, the better -- at least up to the point where you start to duplicate your efforts. Active and passive funds can each have a place in your portfolio, and so do the high-flyers. Just make sure you haven’t taken more risk than you intended.

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