John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Since 2007, investors have poured close to $1-trillion (U.S.) net into U.S. index funds – those that track broad market indices composed of hundreds of stocks, according to the Investment Company Institute, the national association of U.S. investment companies. And they have pulled more than $650-billion net out of actively managed U.S. mutual funds.
The rationale for the exodus of active money into passive index funds is simple: Over the long term, many studies show, most active fund managers fail to beat major indices such as the S&P 500. So why pay the 2-per-cent fees that many active funds charge when you can invest in an index fund for a fraction of that cost? Plus, an index such as the S&P 500 is designed to be representative of the U.S. economy. Invest in an active fund, and you could be trusting a so-so manager to make big bets on individual companies. Index funds provide a much safer, more diversified option, the thinking goes.
But that is not entirely true. Most major index funds are market-capitalization weighted, meaning that the larger a company's market value, the greater weight it has in the index. In the United States, that means that the eight most heavily weighted firms in the S&P 500 account for more of the index than the 255 lowest weighted companies. While fundamental index ETFs, which weight holdings based on economic factors such as sales or profits, have gained some steam, the largest index funds are still market weighted.
In Canada, the S&P/TSX composite index is even more top-heavy. The index is composed of close to 250 stocks, but the top 10 holdings account for close to 40 per cent of the index. Investors who buy an S&P/TSX index fund thinking they are spreading their bets across a wide swath of companies are, in fact, making some pretty big bets on a small number of firms.
Of course, if an index is going to represent the broader economy, larger companies should indeed be more heavily weighted. But often, the big guys have a much greater weighting than the size of their businesses would dictate. Royal Bank of Canada, the most heavily weighted stock in the S&P/TSX, has about 20 times as much in trailing 12-month sales as Trican Well Service, which has the lowest weighting. But RBC is weighted more than 600 times more heavily than Trican in some S&P/TSX index funds.
As more people pile into index funds, an outsized portion of their investment goes toward the biggest stocks. Noted strategist David Winters, who manages the Wintergreen Fund, recently told WealthTrack that he fears this is creating a cycle in which large, hot stocks get pushed higher and higher – perhaps, in the U.S. at least, into bubble territory, he says.
Another factor to consider about S&P/TSX trackers: Close to 75 per cent of the index is composed of just four sectors: financials, energy, materials and industrials. Part of that is due to the way the index is weighted; part is due to the nature of Canada's economy.
If you are looking for broader diversification, look outside of Canada. In the United States, many funds tracking the S&P 500 and other major indices are also top-heavy. But the size of the U.S. market means there are thousands of investable stocks that fall outside its major indices.
I think the thousands of smaller U.S. stocks that are not in the S&P 500 and the hundreds of smaller Canadian stocks not in the S&P/TSX composite are fertile ground for bargain-minded investors.
What sort of bargains? I recently used my Guru Strategies, each of which is based on the approach of a different investing great, to look for attractive, fundamentally sound U.S. stocks that are not in the S&P 500. Here is a trio that caught my eye.
REX American Resources (REX-NYSE)
In fiscal 2009, REX completed its transformation out of retail and into the alternative energy industry. It has interests in several ethanol production facilities in the Midwest and Northern U.S. REX gets strong interest from the Kenneth Fisher-based model, which likes its 0.7 price-to-sales ratio, lack of any long-term debt and $15.68 in free cash per share.
WSFS Financial Corp. (WSFS-Nasdaq)
This Delaware-based firm has offices in all three counties of Delaware, southeastern Pennsylvania and northern Virginia. It is a favourite of my Peter Lynch-based model, which likes its combination of a 38 per cent long-term earnings-per-share growth rate and 10.4 price-to-earnings ratio.
Sanfilippo & Son Inc. (JBSS-Nasdaq)
This nut and snack food processor has increased its earnings per share in each year of the past half-decade, one reason it gets high marks from my James O'Shaughnessy-based model. Another: Its combination of momentum (94 relative strength) and value (0.6 price-to-sales ratio).
Disclosure: I'm long REX, WSFS.