Noah Fisher, CFA, Research Analyst
nfisher@haverfordquality.com
Another Curveball in 2020: Major Market Indexes are No Longer Diversified
Did you know if on August 31, 2020 you purchased an index fund or an exchange traded fund (ETF) that is benchmarked to the Russell 1000 Growth index, your portfolio would have a 12% weight in Apple, a 10% weight in Microsoft, and an 8% weight in Amazon? This is a predicament many U.S. growth mutual fund managers wrestle with every day because The Investment Company Act of 1940 set portfolio construction limitations for mutual funds to be classified as “diversified.” According to the U.S. Securities and Exchange Commission (SEC), a mutual fund that is classified as “diversified” cannot have more than 25% of their portfolios invested in individual positions each greater than 5% of assets. Therefore, to comply with the limitations, many investment managers are underweight Apple, Microsoft, and Amazon relative to their benchmark.
The Russell 1000 Growth Index is a market-capitalization weighted index and subset of the Russell 1000 constructed to provide a comprehensive and unbiased barometer of the large-cap growth market.
This relative underweighting has had negative performance implications year-to-date. As the chart below highlights, companies outside the top 5 have posted negative returns year-to-date. Haverford’s investment discipline seeks to construct a highly diversified portfolio, which may make it tough to outperform narrow markets, such as we have today, but will hopefully cushion downside volatility that is sure to come.
Source: Goldman Sachs, as of September 11, 2020
The rise of these top stocks comes not just from fundamental reasons, but also due to increasingly optimistic sentiment. Sentiment can be measured in the price-to-earnings (P/E) ratio investors are willing to pay to buy shares in a company. The higher the P/E ratio, the greater confidence in the company’s future prospects. Investors have become increasingly (perhaps, overly) confident in a rosy future for these companies, which has not always been the case. For example, both Microsoft and Apple currently trade at over 30 times expected earnings, yet just three years ago both stocks traded for less than 20 times earnings. A high P/E ratio does not necessarily mean a stock is overvalued, as low P/E stocks can be overvalued too; it just means the bar to meet and exceed investor expectations is elevated. There is a simple formula: happiness = reality minus expectations. Future returns for the stocks can be boiled down to a similarly simple formula.
