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Your portfolio is probably heavy on index funds. Now may be the time to make changes

Russ Wiles
Index funds have become hugely popular, and they account for a large following in 401(k)-style retirement plans. They're also reliant on tech stocks.

Ten years into the stock market rally, it's wise to be vigilant for signs of overheating.

While the economy continues to expand — and no serious market downturn seems imminent — it never hurts to be prepared.

Research Affiliates, an investment company in Newport Beach, California, recently updated a bubble watch it started a year ago in an attempt to identify assets that could be seriously overvalued and thus prone to a tumble. Its list includes bitcoin, Tesla stock and many index funds.

Of these, index funds are the most relevant possible bubbles for many mainstream investors. These funds have become hugely popular in recent years, and they account for a large following in 401(k)-style retirement plans.

If you have money in the stock market, you probably own an index fund somewhere, including through target-date retirement funds that own stocks and other assets in mixes that are appropriate for investors of specific ages.

Research Affiliates, in its latest report on bubbles, isn't arguing against indexing per se. Nor is it calling for a stock-market crash, though the company's chairman, Rob Arnott, said he views the market as expensive. Rather, the firm cautions that some index funds, concentrated as they are in large technology stocks, could be vulnerable.

The warning is relevant given the persistent growth of index funds, which held 33% of all 401(k) assets as of 2016, according to a recently released study by the Investment Company Institute and BrightScope. That was roughly double the percentage of a decade earlier.

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Some investors who now hold index funds likely didn't during the bear market of 2007-2009, meaning they might not realize how volatile the funds can be in a slide.

How indexing works

Index funds are investments that hold the same stocks as found in various market indexes or baskets, such as the 500 large U.S. corporations represented in the Standard & Poor's 500 index, the 100 or so tech and other stocks in the Nasdaq 100 or the roughly 2,000 smaller companies in the Russell 2000.

Index-fund managers don't try to cherry pick stocks that might outperform. Instead, they hold a pre-selected list of companies, basically conceding that beating the market is a tough if not futile task. Index funds don't spend a lot of money on high-priced investment teams, and they pass these cost savings along to shareholders.

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Funds that track the 500 stocks in the S&P 500, and other funds like it, base their  selections on company size or capitalization — the value of a corporation's shares in the stock market.

This means the top 10 or so holdings will exert much more influence on a fund's performance than the bottom 10 or perhaps even the bottom 100.

The problem, argues Research Affiliates, is that capitalization-weighted indexes like the S&P 500 are abnormally concentrated these days in "pricey and overvalued" large tech companies.

"Most of these tech stocks are trading at valuations nearly as rich as they have ever traded," according to the firm's report.

Will bubble stocks burst?

For these stocks to keep up the momentum, the companies would need "near-perfect execution" of their business strategies to continue generating the profits that investors have come to expect, according to the report.

Some of the most prominent giant tech companies, such as Alphabet (parent of Google) and Facebook, derive the bulk of their revenue from advertising. Yet advertising is an expense that often gets cut during slowdowns, noted Research Affiliates.

The investment firm cites Netflix, Twitter and Chinese giant Tencent as other bubble tech stocks, but it doesn't consider Apple and Microsoft to be in the same camp.

"Others, like Amazon, might or might not currently qualify as bubble stocks," said Research Affiliates. "We could make the case either way."

Changing tech leaders

At any rate, the FANMAG stocks — Facebook, Amazon, Netflix, Microsoft, Apple and Google/Alphabet — are collectively worth $4.5 trillion. That gives them a huge weighting in the S&P 500 and other index funds pegged to large companies.

Together, they have more value than all but a couple global stock markets, Arnott said in an interview.

"Are these six companies worth more than the entire (United Kingdom) or German economies?" Arnott said. "One or two might exceed the lofty expectations baked into their prices, but most probably won't."

Around the time the tech-stock bubble burst in 2000, the biggest companies back then included Microsoft, Cisco, Intel, IBM, AOL/Time Warner and Sun Microsystems. Most remain healthy corporations and some, like Microsoft, are still market leaders.

But the investment returns of those big tech stocks have lagged and some, like AOL and Sun, have been absorbed by other entities.

Defining bubble investments

One way to determine overvaluation is whether a company has ample cash and cash flow, and a moderately low valuation, that it could plausibly continue to deliver superior profit growth and investment returns.

If not, it could be a bubble ready to burst.

Two bubble traits cited by Research Affiliates are these: A typical bubble stock is so overpriced that it isn't likely to outperform less-risky assets like bonds or cash. Also, investors who keep buying bubble stocks are ignoring traditional valuation measures.

Index funds focused on large tech stocks essentially are making "ever-increasing bets in overvalued securities," Research Affiliates continued.

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Right now, you might not feel like pruning your index-fund holdings. The S&P 500, for  instance, outperformed 82 percent of actively managed large-stock mutual funds over the five years through 2018, according to S&P Dow Jones Indices. Index funds pegged to the S&P 500 have done similarly well.

Carolyn Wegemann, a spokeswoman for indexing heavyweight Vanguard, asserted that broadly based index funds "intend to capture the performance of a wide range of stocks" in many industries and should be held as long-term investments.

"Each sector has years of outperformance and underperformance, and there is no way of predicting how a particular sector or stock will perform," she said in an email, while also questioning whether large tech stocks are trading now at especially high valuations.

How index funds differ

Not all index funds focus on large stocks or technology giants. Some emphasize smaller companies, foreign corporations, those in specific industries and so on. Some index funds are equal-weighted, meaning each stock in the fund exerts the same impact on performance. Others base their holdings on factors other than capitalization or size, such as companies with superior earnings or dividends.

But index funds tied to large tech stocks appear perilous now, and the exposure of many such funds to these companies is double what it was just five years ago, argues Research Affiliates.

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The firm recommends that investors avoid the bubble stocks cited above and, by extension, be wary of index funds that include those companies among their largest holdings.

Hence the importance of understanding what types of funds you're invested in and possibly making adjustments, while times are still good.

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.

This article originally appeared on Arizona Republic: Index funds in your portfolio may be an investment bubble that could pop