Seeking Alpha

Guess Who's Driving Those FAANG Stocks Higher

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Includes: AAPL, AMZN, FB, GOOG, GOOGL, IVV, MSFT, NFLX, SPY, VTI
by: Dale Roberts
Dale Roberts
Long-term horizon, portfolio strategy, bonds, dividend investing
Summary

The famous FAANG gang is driving many of the indices higher.

Many writers and commentators unwittingly blame indexers for blindly driving those stock prices higher.

But guess what, stock markets are actively priced and active managers are driving the Facebook's and Amazon's higher.

It is a popular canard to blame the rise in "passive" index investing for the ongoing and dramatic increase in the stock prices of the popular Facebook (FB), Apple (NASDAQ:AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet/Google (GOOG) (NASDAQ:GOOGL). But guess what, the broad market indices or index funds such as IVV or SPY or VTI do not drive those stock prices higher, the markets are still priced by active managers. Should we call it the Facebook fib?

Articles on Seeking Alpha and around the web of financial reporting continue to blame the indexers, but the markets are not priced by those who invest in passive index funds. A "passive" index fund such as iShares' IVV will simply replicate or mimic the market. The percentage allocations to the FAANG stocks are decided by the active managers, not by the creators of index ETFs such as BlackRock or Vanguard or even Standard & Poor's and the original index creators.

In response to the ongoing misdirection (and to have the truth at the ready), I wrote this article, "Sorry Indexing Is Not The Problem." From that article, from Vanguard research here's the breakdown of who's doing the trading on individual stocks.

A BlackRock study found that ...

For every $1 of US equity trades driven by index strategies, managers seeking active returns (in excess of benchmark) trade approximately $22.

It's obvious that the active managers are still pricing individual stocks and in turn pricing "the market." In my opinion, those who have the most to lose if or when the passive index fund products start to distort the markets and if we ever lose "price discovery" are the leading ETF providers such as BlackRock, Vanguard, State Street, PowerShares and WisdomTree. Those companies will be the first to know, and they'll be the first to report on the event. That's why they are studying the effect of indexing on the overall market characteristics and price discovery.

I recently wrote this back to basics blog on What is Index Investing, perhaps many investors need to start there. When I write and post on Seeking Alpha, it becomes obvious that many do not know what is an index, how they are created or how an index ETF is priced. An index fund that replicates the S&P 500 is simply owning the market leaders in all major sectors. If you own that index fund, you are holding or investing in the most valuable companies in those sectors, including the technology sector that's dominated by those FAANG stocks. Certainly S&P sets the rules for index construction. From there, the companies earn their way into the index by being successful. That success is recognized or rewarded by those active managers who set the price of Apple, Google and Netflix, and on and on. The value of a company is essentially the amount that it would take to buy the entire company. The value of the company is the share count x the share price. Well once again, who sets that share price? It's the active managers. When the share price of a company goes up, the value of the company goes up. Of course, it's possible that Apple could increase its value on any given day more than a comparison to the change in value of Netflix. Given that the S&P 500 is cap weighted, meaning that companies with higher value are given a greater percentage of the index weighting, the funds that track the S&P 500 will increase their allocation to Apple. Again, not because the S&P 500 index thought it was a great idea, but because the active managers think it's worth adding more Apple compared to Netflix. Of course, the S&P 500 index does not think, it follows.

On the weighting of the S&P 500, consider that Apple is the greatest percentage allocation at near 4%, while the 500th biggest allocation within the S&P 500 will be trivial. Here's the top 10 from IVV, a fund that mimics or attempts to replicate that venerable index.

Of course, Microsoft (MSFT) is not included in that popular FAANG list or acronym, but the company is on a tear and is second "place," right behind Apple. Those active managers certainly like Microsoft and are rewarding the company and shareholders (thank you!) with higher stock prices and a greater company valuation. Once again, indexers are going along for the MSFT ride thanks to those active managers. In fact, Netflix is only .74% of the IVV weighting, so one might think that's not a lot of impact on the "market" even though Netflix is included in that popular tech basket moniker.

And speaking of going along for the ride, that's exactly what's happening with the popular tech stocks and active managers. From just over a year ago (May 2017), here's an article from Business Insider that describes the flows of active managers who don't want to miss out on the tech action - Tech Stocks Are Getting A Boost From An Unexpected Source. That article also lists the torrid earnings growth and earnings growth projections for the popular tech grouping. Of course, that's why the active managers love those companies and why those active managers are rewarding those companies with higher share prices - it comes back to business success. That article also describes some of the "stuff" that those active managers will undertake such as short covering that will drive those companies' share prices higher. Once again, it's the active managers driving the prices, not the IVVs of the world. And at the time of the article, the writer states that active managers had a period when they decreased their exposure to the FAANG grouping. That event would have caused the indices to respond in kind as well.

And from last summer even Goldman Sachs knows what's going on in the active mutual fund space...

"GOOGL, AAPL and FB were among the top ten largest increases in fund positions during 2Q 2017," said Goldman Sachs in a research note out Monday.

Goldman also reported that on a sector level, the active managers were greatly overweight technology. See the connection? The active managers are overweight technology, the S&P 500 index funds increase their exposure. The S&P 500 index funds will respond stock-by-stock and sector-by-sector. Keep in mind of course that effect has its limits due to the index construct rules.

Net, net, the Index funds are following, not driving, the prices higher, or driving the changes in sector allocations. And more surprisingly, the active managers have been using the technology allocations to their advantage with a greater percentage of active managers outperforming the underlying passive indices. Of course, active managers might be empowered or able to hold a greater percentage of FAANG stocks and technology stocks as a sector percentage as they might not be bound by such hard and fast allocation rules such as the index funds. Great, go for it.

Bloomberg reported that fund managers were doubling down on tech stocks. Bank of America reported fund managers had the greatest allocation to the tech sector on record, and so on, and so on. Once again, those active managers are not following the S&P 500. The S&P 500 is following the active managers.

Please keep in mind the simple facts. The markets are still priced by the active managers that includes mutual fund managers, pension fund managers, sovereign fund managers, retail stock pickers and others. When you hear about the markets or individual stocks being driven to new heights, or individual stocks with "undeserved" stock prices or valuations, you now know who to blame.

Author's note: Thanks for reading. Please always know and invest within your risk tolerance level. Always know all tax implications and consequences. If you liked this article, please hit that "Like" button. If you'd like notices of future articles, click the "Follow" button.

Happy Investing.

Dale

Disclosure: I am/we are long AAPL, NKE, BCE, TU, ENB, TRP, CVS, WBA, MSFT, MMM, CL, JNJ, QCOM, MDT, BRK.B, ABT, PEP, TXN, WMT, UTX, LOW, BNS, TD, RY, BLK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.