By Mustafa Sagun, Chief Investment Officer, Principal Global Equities

The biggest consensus trade in modern history

The legendary Jack Bogle revolutionized the investment management industry, most notably with respect to passive investing. One of Bogle’s legacies was making such strategies broadly available to retirement plans, retail investors and institutions at low cost. However, based on Principal’s investment philosophy and basic truths about long-term wealth creation, we strongly believe that investors should re-think their reliance on traditional capitalization weighted indexes, particularly in US large caps, as we approach the later stages of a prolonged equity market and economic cycle.

Passively replicating the S&P 500 Index has become the consensus trade, evidenced by the trillions of dollars in index ETFs and mutual funds. Lower costs coupled with most fundamental managers’ underperformance have
really made passive indexing a no-brainer for institutional and retail investors alike. “Beta is enough” is now a commonly accepted thesis to US large caps and seeking outperformance in other segments of global equities.

Like most things in life, cheap and easy isn’t always best. While we are not predicting a recession or a significant and prolonged equity market decline, the massive inflows into passive US large caps gives us pause. As with all trends driven by group-think and reduced risk awareness, the S&P 500 may eventually be in for a “Minsky Moment” if history is a guide. Coined after the economist Hyman Minsky, this is defined as a sudden and major collapse of asset values following a period of relative stability and risk-taking.

Behavioral economics tells us that investors experience gains and losses asymmetrically – the discomfort of a dollar lost exceeds the joy of a dollar gained. The basic math of compounding also clearly illustrates this phenomenon. A 10% loss requires an 11% gain to break even. A 50% loss needs a 100% gain; a 90% loss, a 900% gain. In volatile markets, especially sharply falling ones, passive capitalization-weighted indexes tend to be painful reminders of the importance of seeking to mitigate downside risk and that simple beta is cheap – for a reason!

Overlooked risks of the S&P 500
Early advocates of smart/strategic beta argued that the S&P 500 and other capitalization-weighted indexes are structurally flawed. Principal’s modern thinking redefines the “market” while challenging the assertion that capitalization-weighted indexes are “good enough”.

By definition, a capitalization-weighted index assigns increasing weights to companies that have appreciated in price and decreasing weights to companies that have depreciated in price, an investment strategy akin to buying high and selling low. The upshot is that capitalization-weighted indexes expose clients to both the upside and
downside periods of frothy valuations, as these indexes tend to chase bubbles up and get crushed on the way down, causing excessive and, in our view, unnecessary volatility.

Japan in the late 1980s is an extreme example of capitalization weighting gone wrong. Stocks on the Nikkei had risen so high that they comprised nearly half of the entire global market index, based on the expectation that Japan would continue to lead the world in technology. A decade later, after the bubble burst and the ensuing Japanese market decline, the index weight had shrunk to about 10% – a disastrous outcome for passive global equity investors. More recent burst bubbles include the 1990s dot-com craze, the 2006 US housing crisis, and the 2017 shale oil collapse, all of which amplified passive investor losses.

“Success breeds complacency. Complacency breeds failure.” — Andy Grove, Intel Co-Founder

We believe this quote is particularly applicable to the massive pools of assets that currently passively track the S&P 500. Convincing clients of the merits of active management isn’t easy in the face of strong market performance. Let’s face it: who cares about a percent or two of excess return when the market is already providing double digits? That calculus shifts markedly, however, when returns are single digit or negative in later market stages. We believe our strong conviction in rethinking passive S&P 500 replication is both timely and supported by our intensive efforts in researching and developing strategic beta and portfolio construction solutions for clients around the world.

In our view, an optimal US large-cap strategy participates on the upside and seeks to protect on the downside, with reasonable fees and implementation costs, and no large, unintended concentrations of style risk. In our work with clients, we have analyzed the S&P 500 and its downside risks at length in evaluating low-cost strategic beta solutions for portfolio implementation. Our goal is to create options with a better risk-return trade-off than the S&P 500 in the form of higher returns and/or lower volatility.

Isn’t the S&P 500 too efficient to bother with active management?

Mega caps are the foundation for traditional capitalization-weighted large-cap indexes. For example, the top
50 stocks in the S&P 500 account for approximately 50% of its market capitalization. In our opinion, most
investors should own these 50 stocks in somewhat similar proportion to their capitalization weight. As the
most widely covered by analysts and other experts, they represent the most efficient part of the index where
it is most difficult to uncover differentiated insights to add value fundamentally. From an outperformance
standpoint, the remaining 450 companies and beyond has been where the action is…

The preceding was an excerpt of a white paper produced by Principal Portfolio Insights, a partner of Nasdaq. For more information or to request the full white paper including all supporting graphics, visit principaletfs.com