Sector Distortions Can Be Costly In Passive Investing

by: AllianceBernstein (AB)

By Joseph G. Paul and Kevin Simms

Passive investing strategies that emulate an index have become increasingly popular. But passive investing can go awry when sector concentrations leave investors exposed to unintended risks.

We've seen distortions in broad stock indices before, and it tends to end in tears. Just before the tech bubble burst in early 2000, the 20 biggest US stocks-mostly technology names-would have accounted for 40% of the S&P 500 Index and dominated an indexed strategy (Display). Likewise, before the financial crisis years, an indexed strategy would have had almost 35% allocated to the 20 largest US stocks, including some financial companies that were hit hard in the crash. And today, high-yielding stocks are at record levels in some benchmarks.

Owning 500 stocks in an index might feel like effective diversification, but when sectors are mispriced, it can be dangerous. Active strategies are capable of avoiding this type of concentration and the damage that often strikes when the distortions unwind and benchmarks get battered.

Even smart index strategies-such as those targeting a particular style like value-are blunt tools that may do damage in an effort to do good. For example, financial stocks account today for nearly 29% of the MSCI World Value Index - about 57% more than the MSCI World (Display). Meanwhile, utilities stocks made up 6.6% of the MSCI World Value Index, or 70% more than the broader benchmark. As a result, investors in the passive MSCI World Value Index would be exposed to heightened risks in financials and a tilt toward safety in utilities.

Here's why. While the value index is heavy on financials, not all financial stocks have equal return and risk characteristics. Some banks have aggressively shrunk their balance sheets and raised capital levels since the financial crisis. Banks like these have been able to focus on rewarding investors through buybacks and/or dividends, while alleviating the risk of diluting existing shareholders by raising more capital in the future. Many still have attractively valued share prices. In contrast, some large banks in Spain and Italy haven't cleaned up their balance sheets and are much riskier, yet they would probably be included in a passive value index owing to their cheap valuations.

In utilities, many companies might look cheap on standard metrics such as price/book and price/earnings value. However, compared with their own history, valuations are actually rather high. In addition, utilities today may be highly vulnerable to an improvement in expectations for economic growth-which could prompt a downturn for defensive stocks. A value index cannot understand either of these nuances, so it loads up on the sector.

Similarly, in the pharmaceutical industry last year, cheap companies that focused on dividends and share buybacks outperformed, while other attractively valued companies that used cash for non-accretive acquisitions were punished by the market. Passive value indices would have included both types of companies, and wouldn't have been able to capture the potential for management action to unlock value by deploying capital reserves. The passive strategy would also have ignored patent loss risks, pipeline potential and the effects of government regulation changes, all of which differ between companies.

Fundamental research and company meetings are crucial to forecasting the dramatically different outcomes that management decisions can create. In our view, active management with effective risk controls is the best way to capture the potential of attractively valued stocks without getting trapped by distorted sector exposures.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph G. Paul is Chief Investment Officer-US Value Equities and Kevin Simms is Chief Investment Officer-International Value Equities, both at AllianceBernstein.