Large Cap Core Funds: Growth Funds in Hiding?

US Large Cap Core Funds: Historical Weights at Various Levels of Valuations

• The chart below shows the average weights at different levels of valuation of a typical index fund made up of large cap companies from 1978 – today
• The bar on the left shows that, over history, investors in a large cap core equity fund had 59% of their money invested in stocks valued at below 2x price to sales, on average
• The second bar from the left shows that, over history, investors in large cap core equity funds had 23% of their money invested in stocks valued between 2x – 4x price to sales, on average
• Looking at the next three bars, you can see that, historically, investors had very limited exposure to stocks valued at 4x – 6x price to sales (8%) with even less at 6x – 8x (4%) and even less at 8x – 10x (2%)
• At the far right, you can see that, historically, investors had very limited exposure to stocks valued over 10x price to sales (4%)

To summarize, historically, investors in large cap core index funds had the bulk of their money invested in stocks with reasonable valuations with negligible exposure to stocks valued over 10x price to sales.

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As the next slide shows, that is no longer true today.

US Large Cap Core Equity Funds: Historical vs. Today at Various Levels of Valuations

• The navy blue bars show the same weights as in the chart above – the average exposure of a large cap core index fund investor to stocks at various levels of price to sales
• The light blue bars show the average exposure of large cap core index fund investors to stocks at various levels of price to sales today
• The contrast should evoke caution for those using index fund investment strategies with large cap core exposure to make sure they are consistent with your investment objectives, risks, and other goals

Large cap core mutual funds now have high levels of exposure to stocks so expensive they are usually the province of growth funds. Growth index funds emphasize more volatile and risky stocks in the name of “capital growth.”

Large Cap Core: Today vs Dot.Com

• Index fund investors’ exposure to stocks at excessive valuations with historically poor payoff structures is not without precedent – unfortunately, the precedent is not a good one
• The red bars show the levels of exposure during the dot.com bubble in 2000 before the most expensive and vaunted growth stocks fell precipitously and inflicted terrible damage on investors
• The light blue bars show large cap core index funds’ exposure today (identical to the chart above)

The similarities between the core indexes’ exposure to overpriced firms today and in December of 1999 is disconcerting. The recent sell-off in equities has caught many investors off guard. What should be more surprising is that after the recent declines, investors in traditional large cap index funds are carrying valuation exposure almost identical to levels in 1999 that were the precursor to a -44.44% return.^[1]

KCR would be remiss if we did not remind investors of their exposure to the bars on the far right. Despite the sharp sell-off in some of the market’s most expensive stocks, large cap core index fund investors still have 16% of their money exposed to stocks valued at over 10x price to sales.

As our quick note on Scott McNealy’s legendary quote explained, this is a valuation bucket that defies common sense. We have all read about the soaring popularity of index funds, and the portfolio managers here at KCR actually sub-advise an all-cap index fund. We believe that beta with minimal charges and expenses serves as a valuable tool for investors.

At the same time, however, as our piece Asset Allocation in Bear Markets explained, the need to monitor value and growth factor exposure was and continues to be significant. This piece adds to our note Tesla Price to Sales Ratio & the Coming Tax on Index Funds by highlighting that even core indexes look like growth funds today.

We continue to believe that the recent demise of celebrity portfolio managers of now-notorious active funds has added fuel to the belief that index funds are the only solution. Please read our brief and simple piece on the Vanguard Small Cap Index Fund to see how even an incredibly simple rule, based on overwhelming empirical evidence (and common sense), can help improve investor outcomes.

The asset management industry is full of superb active managers who have long histories of providing returns above market levels with low costs, low turnover, and excellent tax efficiency.