Whether they know it or not, most investors have at least some exposure to the stocks known as the FAANGs (Facebook, Amazon, Apple, Netflix, Google), or FANMAGS, if including Microsoft. Making up approximately 23.7% of the market capitalization of the S&P 500 as of September 30, 2020, it’s nearly impossible to avoid them when invested in a passive-managed fund or ETF. Unto itself, this is a good thing. Generally, as industry leaders, these companies have proven their resiliency during the pandemic and, in some cases, found themselves perfectly positioned for a nation in lockdown.
There’s a semantic dilemma, however. These investors likely allocated their money while assuming their funds would be deployed into a well-diversified portfolio that’s tracking the U.S. economy overall. In reality, an investment in the S&P 500 is actually more like two portfolio investments in one. One is a portfolio consisting of the six FANMAG stocks following an ‘V’-shaped recovery while the rest comprise a portfolio following an ‘L’-shaped one. In such a situation, the obvious question should be: How to reconcile the two?
Despite the pandemic, the S&P 500 has performed very well in 2020. For investors, that’s the number one takeaway. Upon closer inspection, however, it is apparent that the driver is not the economy itself as much as it is simply the FANMAGs. In fact, when excluding the FANMAGs, the rest of the Index has actually declined. This holds true for approximately the previous five years, with 2015 serving as the point when the FANGMAG’s performance began to materially diverge from the rest of the S&P 500.
One never wants to look a gift horse in the mouth, but an astute investor sees a disconcerting pattern here. While a crowded, top-heavy S&P isn’t exactly new and while those stocks will naturally drive outperformance vs. the remaining members of the Index, this ever-expanding divergence is a concern. In the face of such unpredictable events and so much vague and ambiguous information, this “two portfolio effect” is noteworthy.
Indeed, with increasing frequency, it seems like more and more market watchers are spotting this trend and warning of its dangers. But the obvious question to ask is: what is an investor to do about it? Some seem to imply that investing in the S&P 500 is a mistake and, therefore, avoiding it altogether is the only course of action. But that’s patently unrealistic. More likely, these pundits are noting this dichotomy with flashy headlines but offer very few actionable solutions.
The FAANGS Aren’t Venomous…
To be sure, one could make much worse decisions than investing in the S&P 500. No less than Warren Buffett is notable for advising a threadbare strategy involving a low-cost passive strategy that tracks the S&P 500. However, given the “two portfolio effect” found in the S&P 500’s components currently, the means of tracking the S&P 500 also has distinct approaches, involving the weighting of said components. In the most commonly tracked and most famous version of the S&P 500 the components are market cap-weighted. That is, the largest components by market cap take up a similarly larger weight in the Index. Thus, with the rise of the FANMAG’s market cap has come a rise in their dominance of this market-cap weighted Index.
There is more than one way to weight an index, of course. The S&P 500 can also be equal-weighted with each component taking up the same weight. The performance of these respective Indexes is presented below.
Since 2002, the equal-weighted Index has generally outperformed the traditional market-weighted Index. This is because smaller stocks have greater weights than they do in a market-cap weighted Index, and smaller stocks also tend to have greater returns due to their risk. This isn’t always true, though, and 2020 is a case-in-point. The crowding caused by the FANMAGs at the top of the Index accelerated as COVID struck and drove much of the outperformance of the market-cap weighted version.
Unto itself, this change is noteworthy. Viewed another way, however, we can compare the respective S&P 500 Indexes to three different SmallCap Indexes—each weighted by scores rather than market cap—and discern additional details.
Through the longer term, from approximately 2013 to 2017—the same period the equal weighted S&P 500 Index generally outperformed the market cap-weighted—the SmallCap Growth and Quality Indexes clearly outperformed both S&P Indexes. And then, from roughly 2017 through 2018, the difference became even more acute. However, in similar fashion to the S&P 500, late 2019 marked a reversal for everyone. While the market had grown slightly unsteady at that time, the common shift affecting all of the Indexes is the pandemic at the beginning of 2020. The obvious driver of this reversal was the pandemic. Each Index suffered, but the Small Caps generally corrected farther to the downside. In this light, the shift in the equal- and market cap-weighted S&P 500s can also be seen as a size bet that similarly changed as the market inflected.
In both cases, weights were the key consideration. Whether it was market cap-weighting or size, each approach could have been beneficial for performance at specific times. Yet, inevitably, these otherwise unrelated approaches—weighting style and size preference—led to a major shift in performance eventually. In other words, it was the weighting of them that dictated the intentional or unintentional bias in the portfolio. The literal selection of the S&P 500’s components was never the issue.
…But It’s Still Nice To Have An Antidote Available
We believe if you want a different outcome you must take a different approach. Over approximately the last 30 years, market cap-weighted indices such as the S&P 500 have tracked the market’s upward climb in a boom cycle—and crashed just as precipitously during a bust. Many explanations for this exist but, to us, this is a natural by-product of market cap weighting. After all, weighting by market cap is just another way of overweighting overpriced stocks. The more a stock goes up, the greater its weight. For the FANMAGs, this approach has helped maintain their upward climb. But how can we tell when weight has morphed from a strength to a risk? For this, we must examine human behavior. We believe that humans interpret vague and ambiguous information in a systematically incorrect way and this information is then impounded into stock prices, leading to mispricing. We call this risk caused by human behavior the H-Factor.
The Efficient Market Hypothesis holds that all information—both the known (ex. financial statements) and vague and ambiguous information—is priced into a company’s stock. We disagree, however, that such information has been priced in correctly. As it relates to the FANMAG stocks, the choices for addressing their overweighting have been limited to tacit acceptance or avoidance. Yet, divesting prior to a bust involves forecasting the future, which is both impossible and a prime example of the H-Factor at work. And, as we’ve illustrated, shifting between a market cap-weighted approach and an equal-weight approach only leads to additional market timing concerns. A different approach is required.
At New Age Alpha, we take an Index such as the S&P 500 and we make it better. The H-Factor methodology is the process of using a probability to determine how much vague and ambiguous information has been priced into a company’s stock price. The higher the probability, the more likely the company will fail to deliver the growth to support the stock price and the more likely it will be a loser. We crafted the New Age Alpha U.S. Large-Cap Leading 50 Index by selecting the 50 stocks in the S&P 500 with the lowest H-Factor scores and, after applying select liquidity screens, we weighted them according to a rules-based, proprietary methodology. The result is a portfolio comparable to the S&P 500 that has the potential to outperform yet overlaps very little with its biggest components.
Consider the ten largest components of our Index and their weights compared to that of their universe, the S&P 500, as of September 30, 2020:
Note that, while Amazon, Facebook, Google and Microsoft are components of the NAA Leading 50 Index, their weightings are based on their respective H-Factor, which doesn’t place them within the top ten holdings. This is pivotal. At New Age Alpha, we manage risk like an actuary, not like a portfolio manager. Our goal isn’t to pick winners but to actively avoid losers. By focusing only on the known, rather than the unknown, we’ll invest in such members of the FANMAG sextet if their respective H-Factors dictate, but their weights won’t become so outsized relative to the rest of the portfolio.
Let’s check the results of our H-Factor methodology at work:
The backtested NAA U.S. Large-Cap Leading 50 Index has consistently beaten the S&P 500 Index. And—of critical importance—it did so with a portfolio of stocks relatively uncorrelated with the stocks most commonly held by the S&P 500. If a crash were to occur in the FANMAG stocks tomorrow, our 8.0% total holdings would lead to far different results than a portfolio with a total of 23.7%. This is the strength of H-Factor methodology. Combined with our, “No Alpha, No Fee,” guarantee 1 that ensures you don’t pay if we don’t outperform the benchmark, it creates a new, powerfully differentiated approach to investing. By stripping this risk of human behavior out of a portfolio, we believe we can generate outperformance in a truly uncorrelated style. Investment in the S&P 500 remains a basic pillar of proper investment, despite repeated dire prognostications about its tech-heavy largest components. That said, an investor shouldn’t be forced to tacitly accept cap-related overweights or unintended size bets. At New Age Alpha, we propose a different option. You don’t need to replace the FAANGs in your portfolio, you simply need to complement them with an antidote if they bite.
New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC and New Age Alpha Advisors, LLC (“New Age Alpha Advisors”). Investment advice is offered through New Age Alpha Advisors, LLC a wholly owned subsidiary of New Age Alpha LLC. New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.
This material should not be construed as an offer to sell or the solicitation of an offer to buy any security. We are not soliciting any action based on this material. It is for general information purposes only. To the extent that it includes references to securities, including FB, AAPL, AMZN, NFLX, GOOG, or MSFT, these references do not constitute a recommendation to buy, sell or hold such security, and the information may not be current. There is no intention for New Age Alpha to include these securities in its portfolios unless they become part of the established universe of eligible securities that are part of each specific investment strategy.
Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this material, will be profitable or equal to corresponding indicated performance levels. Any charts, graphs or tables used in this Research Paper are for illustrative purposes only and should not be construed as providing investment advice.
Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated, does not give effect to any fees or costs of trading and should not be considered indicative of the skill of New Age Alpha.
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1 In instances where doing so is permissible under applicable law and agreed to in advance with a client, New Age Alpha will rebate its management fee for each client that experiences negative performance as compared to an applicable broadbased securities market index benchmark for any three (3) or more consecutive months. The terms of any rebate that are applicable to a client will be specified in the client’s investment agreement.
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