Large Cap Growth Index Funds & the Path to Poverty

A Quick Peek at the Russell Large Cap Growth Index

Understandably smitten with low fees and a long bull market, index fund promoters appear to have the data on their side. A collection of financial heretics, the authors of this investment newsletter have highlighted what we believe are the defects endemic to index funds today. In the interest of simplicity, we have used single factors to highlight just how these popular and heavily promoted products are ripe for disaster.

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In our piece Tesla PS Ratio & the Coming Tax on Index Fund Owners, we explained the nonsense in large cap core funds. In Vanguard Small Cap Index Fund: The Myth of Low Cost Indexing, we highlighted how investors were exposing themselves to needless financial losses. Both pieces relied entirely on empirical evidence.

The conclusions were drawn from historical evidence and not predicated on forecasts. We are in the moneyball business, not the crystal ball business. You don’t need a Ph.D. to understand the problems we highlighted.

Contrary to what you may have heard: there are numerous providers of low-cost, tax efficient, and high-quality active managers who can help you avoid the empirical failures that have, in our view, taken index funds too far.

So, today’s task is to tackle the Russell 1000 Growth Index Fund complex. This will be one of the most simple, straightforward, and empirically obvious things you’ve read this week. Here it is in one chart:

The top 30 names in Russell Large Cap Growth Index Funds make up ~65% of the index weight.

• When you buy an R1000G index fund, you are putting nearly 2/3^rd of your money into just 30 stocks
• It is very tough for that index to make you money if those 30 stocks don’t keep going up
• In theory, the 30 largest names could just keep getting bigger and drive the R1000G higher
• When you buy a passive large-cap growth index fund that is effectively the “bet” you are making
• KCR believes the historical data is clear: that is not a bet you want to make

Investors have shown some newfound interest in large-cap growth stocks. Understandable. They’ve sold off.

But how much? The chart below divides the market cap of the 30 largest growth stocks by GDP. These companies have indeed fallen….to where they were at the peak of the dot.com bubble. That is sheer madness.

Does it make sense to have 30 stocks in the United States valued at half the country’s GDP? It has never made sense before. Maybe it is different this time, but we doubt it.

Note: we have faced intermittent pushback on the Buffett market cap to GDP metric. Please see our notes at the bottom for more information on why we believe the method is so powerful.

Summarily:

• The large-cap growth indexes have concentration levels in the top 30 weighted stocks last seen at the peak of the dot.com bubble
• The last time we got here, the weight of those supersized firms would subsequently implode
• Despite recent declines, the 30 largest stocks are at the same valuation that the 30 largest stocks were at the peak of the dot.com bubble when scaled by GDP

SO, WHAT DOES HISTORY TELL US?

The prior peak in concentration was on March 31, 2001. We looked at the performance of the 30 largest stocks over the next six years. The chart below shows the results.

Nearly 80% of the top 30 experienced losses on an absolute basis over six years. Only one stock, Cisco, was able to generate returns of ~10% a year (right-most bar, +60% over 6 years). Ask yourself: do you want to play this game?

KCR understands the importance of diversification, index funds, and avoiding trying to time markets. An allocation to a large-cap growth fund is a component of any portfolio. But like our work on small-cap and large-cap core index funds, this quick study of the Russell 1000 Growth index exposes a massive flaw in portfolio construction.

Fortunately, this flaw can be easily remedied by a low-cost, evidence-based active manager with a lick of common sense. The table below compares the largest 30 growth stocks in the index to the top 30 ranked growth stocks in our Large Cap ranking model.

What’s remarkable comparing the two rows is that despite trading at a significant discount to the 30 largest stocks, our growth picks offer identical net profit margins, a 2% kicker on total yield (6% vs. 4%), and faster earnings growth. Pay less. Get more.

For a list of our top picks, please see at the bottom of this page or login below.

NOTES on Market Cap to GDP:

That pushback flies in the face of the statistical evidence and requires a belief that it is “different this time.” We wholeheartedly respect that people will hold opinions that conflict with our own.

To see the statistical data that supports the metric’s validity, we encourage you to read The Buffett Valuation Metric, The Costliest Stocks: A Lifetime Earnings Analysis, or the ultra-brief Warren Buffett’s Market Cap to GDP piece.

Our work, Economic Cycles and Means Reversion, explains why globalization and the highest margins in 100 years have done nothing to diminish the importance of this metric. If you’d like to hop on the phone and discuss, please let us know.