Stocks continued their advance during the first quarter of 2017. Several of the mutual funds that we use also generated positive returns, and absolute performance over the past year has been more in line with what we would expect from the value strategy.
We often receive questions regarding the benchmarks that we include on the quarterly reports. These benchmarks are comprised of indices such as the Russell 1000 (representing large stocks), Russell 2000 (representing small stocks) and MSCI EAFE (representing international stocks). Like the S&P 500, all of these indices are market-cap weighted, meaning that companies with the largest market capitalization (stock price multiplied by the number of shares outstanding) are held in greater quantities than companies with smaller capitalizations.
The reason that we do not simply invest in cap-weighted index funds is that we believe there is a risk of acquiring over-priced stocks implicit in this strategy. The largest companies by capitalization can sometimes become “glamour” stocks: darlings of investors because of their recent growth and rosy projections. Unfortunately, there is little margin for error with such investments. If earnings growth doesn’t materialize as projected, stocks that were previously “priced for perfection” can underperform.
We think the potential downside of cap-weighting can be seen by comparing the standard indices against their equal-weighted counterparts. For example, $10,000 invested in the cap-weighted MSCI All Country World Index (a good proxy for worldwide stock exposure) in 1999 would have grown to $21,541 by 2016. If one had bought the same basket of stocks, but weighted them equally instead of according to capitalization, the ending value would have been $40,223 – almost twice as much (data from Morningstar). This disparity exists despite the last six years in which the cap-weighted strategy has dominated.
The torrent of money that has been flowing into cap-weighted strategies is actually a reason for optimism as it may result in a greater number of mispriced stocks. In his recent shareholder letter, Baupost Group’s Seth Klarman opined that the casting aside of stocks not favored by the indices “…should give long-term value investors a distinct advantage. The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”
All this is to say that the cap-weighted benchmarks that you see on your report have limited use in assessing the efficacy of a value-oriented investment strategy. We include the indices because they are widely recognizable comparison tools, but index funds will one day fall out of favor as well. Ultimately, the primary goal in investing is not to beat a benchmark. The primary goal in investing should be to achieve returns necessary to attain one’s stated financial objectives, while minimizing unnecessary risk. If you have questions about your progress toward your financial goals in light of the investment returns, we invite you to give us a call.
Aaron Pettersen, CFA, CFP®