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These five stocks are eating up your index fund. Here’s a better strategy for investing in this market

May 30, 2020, 11:00 AM UTC

Not since the tech bubble of the late 1990s has the S&P 500 been so dominated by a handful of richly valued glamour stocks—a cast that in those days starred the likes of Cisco, Lucent, and IBM. Today, the superhot names are the Fab Five: Microsoft (a stalwart in ’99 as well), Apple, Amazon, Google, and Facebook.

Starting last year, their weight in the S&P 500 jumped, then exploded in 2020 as they defied the COVID-19 crisis: The Fab Five, along with the likes of Netflix and Salesforce.com, got much more expensive while the rest of the market got a lot cheaper. So most big-cap funds load you up on the hot names that have been soaring, and go light on what’s beaten down to dirt cheap—think financials and energy. “People risk buying into indexes that are top-heavy with these high-priced stocks,” says Chris Brightman, chief investment officer at Research Affiliates, a firm that oversees strategies for $145 billion in mutual funds and ETFs. “We’ve seen these patterns before, and they usually end in tears.”

The problem with S&P index funds

S&P 500 index funds, and most traditional big-cap portfolios, are usually “cap weighted.” That means the portion of your dollars allocated to each stock simply tracks the market value of each company in, say, the S&P 500 index as a percentage of the total capitalization of 500. If Microsoft’s $1.38 trillion valuation is 5.5% of the S&P total of $26.7 trillion and Facebook’s $660 billion market cap represents 0.25%, the fund puts automatically 5.5% of your money in Microsoft, and 0.25% in Facebook.

The problem: When prices of a few ultra-fashionable stocks rocket far faster than their earnings, a bigger and bigger part of your portfolio will skew toward those pricey momentum plays, and a shrinking portion will go to laggards that offer the best bargains. You’re stuck with a strategy that’s always selling low and buying high. Meanwhile, you’re watching the overall price-to-earnings ratio on your fund, the dollars you’re pocketing in earnings for every dollar you’ve invested, keep rising. The fund is parking more and more of your money in expensive stocks just because they’re getting pricier.

The cap-weighed approach looks like a winner when the index is doubling down on high-fliers that keep climbing. But in most cases, profits don’t wax fast enough to meet those great expectations, fans depart, and the shooting stars deliver poor returns over the next several years. On the other hand, the outcasts the index dumped often do great, because they’re so downtrodden that even if their earnings grow modestly, they’ll deliver an upside surprise.

Research Affiliates ran numbers for Fortune showing how a few stocks with gigantic market caps—most of them boasting king’s ransom valuations—have grabbed a bigger and bigger slice of the S&P 500. By widening the gap between the haves and have-nots, the pandemic lockdown has hastened the trend. To be sure, the big run-up in a handful of marquee names has cushioned losses in cap-weighted funds this year. But it bodes ill for the future: The trampled “value” stocks likely to outperform from here are precisely the ones those funds are ditching to chase what’s hottest, and most vulnerable.

At the close of 2019, the stocks with the five largest market caps in the S&P 500 were the same group as today: Microsoft, Apple, Alphabet, Amazon, and Facebook. They accounted for 16.1% of the index’s total valuation, meaning that if you owned an S&P index fund or ETF, or most other big-cap funds for that matter, you had 16.1% of your money in the Fab Five on Dec. 31. It’s worth noting that in 2017, those tech giants also occupied the top five spots but accounted for just 11.5% of the index’s total value.

The 16.1% concentration was well above the average: Since 1999 the five biggest names have made up 13.2%. This year, the winners-losers divide widened vastly. Let’s step back and compare the picture to a year ago. In the last days of May 2019, the S&P 500 had a total market cap of $24.7 trillion, and the Fab Five had a combined value of $4 trillion, exactly the same 16.1% share they held at year-end. In the 12 months since, despite the roller-coaster ride in 2020, the index has risen to $26.7 trillion, for an increase of $2.0 trillion or 8.1%. By contrast, the valuations of the Fab Five rose by $1.56 trillion, or 40%, to $5.56 trillion. No less than 78% of the entire $2 trillion increase came from those top names.

By the end of May, the Fab Five constituted 21.1% of the S&P’s total valuation. That’s almost twice their share in 2017, and five points, or one-third, higher than their position just five months ago. That number easily eclipses the highest reading in the past two-plus decades, 16.4% marking the height of the tech bubble at the end of 1999. Then, Cisco, General Electric, and Exxon ranked in the top five, with Microsoft the only repeat.

Look what happened to the weights of the five tech champs in the past year. Microsoft’s share of the S&P has gone from 3.9% to 5.2%, Apple from 3.3% to 5.2%, and Amazon from 3.7% to 4.6%. All of the five saw their shares rise by at least one-third.

The astounding advance for the five biggest-cap members, amid a general retreat, is troubling for a basic reason. It’s not an earnings surge that’s driving the Fab Five to new heights, but investors’ stampede to pay ever higher prices for each dollar in profits. Since late May of last year, the total net profits for Apple, Microsoft, Amazon, Alphabet, and Facebook, over their most recent four quarters, have declined slightly, from $148.8 billion to $147.5 billion. But since their valuations have mushroomed 40%, their combined P/E has followed, rising from a lofty 27 to a vertiginous 38. Over the 12 months in which these five companies got 30% more expensive, your fund beefed up on 30% more of them.

The Fab Five aren’t the only super-pricey shares the funds are piling into. A second group, made up of four high-profile tech luminaries, are also taking a bigger and bigger share of cap-weighted holdings, and they’re even more richly priced than the five leaders, by a lot. Since the close of 2019, the combined market caps of Nvidia, Netflix, Salesforce.com, and PayPal have jumped by $200 billion, or 39%, to $729 billion. But since their earnings for what we’ll call the Fantastic Four aren’t nearly as robust as the Fab Five’s, their combined P/E is three times as high at 109. As with the Fab Five, cap-weighted funds bought more and more of the Fantastic Four. This year, their weight in the S&P has jumped from roughly 2% to 3%. Put the Fab Five and Fantastic Four together, and their share in five months catapulted from 18.1% to 24.1%, and the combined P/E for the nine stands at 41.

The S&P would be a far better deal if you didn’t have to park over one-fourth of your money in a handful of players selling at over 40 times earnings.

A better way: fundamental indexing

Research Affiliates pioneered an approach that avoids piling more and more into hot stocks, and instead channels the lion’s share into the distressed, overlooked, and unloved with one feature in common—they’re cheap. The methodology is called “fundamental indexing.” The formula invests dollars based on the company’s size in the overall economy, not its market value as a share of the entire S&P. It deploys four metrics to establish those weights: sales, cash flow, and dividends, each averaged over five years, and current book value. Each metric is given equal importance. “If we only looked at revenues, we’d overweight retailers and airlines,” explains Brightman. “If we used only book value, you’d underweight tech, because they spend a lot on R&D not counted in book, and overweight industrials. Using the four benchmarks gives the right balance.”

Market cap, the only factor that counts in cap weighing, isn’t part of the formula. Put simply, you get a lot more in cash flow, sales, and dividends in a fundamental fund for each dollar invested than in a cap-weighted rival. The most basic comparison is the P/E. Today, the multiple for the cap-weighted S&P index fund is around 27.5. By the way, it’s so lofty in large part because of the huge gains in the Fab Five. That’s been a boon to investors until now, but the ever-more-lopsided approach signals danger ahead.

For the fundamental indexes using Research Affiliates methodology, the P/E is over 40% lower at just 16. Measured in price to book value, the tilt toward bargain stocks is even sharper: In cap-weighted funds, investors are paying 10 times book value, versus around two times in a fundamental fund. Fundamental indexing delivers three times more in cash flow per dollar of investment, and seven times more sales. The “fundamental” dividend yield is 3%, dwarfing the 0.9% from a cap-weighted index.

Research Affiliates oversees a broad family of fundamental funds covering a wide range of portfolios, including international large-cap, U.S. small-cap, large and small for emerging markets, and of course, U.S. large-cap based on the S&P 500. Funds using its formula are managed by Invesco, Charles Schwab, and BlackRock. Among the most popular offerings is the Schwab Fundamental U.S. Large Company Index Fund (SFLNX), which manages $4.4 billion. Because it allocates dollars based on companies’ heft in the economy and not their valuations, the SFLNX places its biggest and smallest weights in totally different places than cap-weighted funds.

Right now, cap-weighted indexes allocate 22.8% of their overall dollars to the on-fire infotech sector. By contrast, SFLNX puts just 19.7% in tech simply because its metrics tag the sector as highly expensive. SFLNX is also underweight in commercial services, home to Alphabet and Amazon. By contrast, it’s far more heavily invested in battered financials (10.2% to 8%), consumer staples (9.7% to 7.9%) and especially the most despised sector of all, energy (7.1% to 2.9%).

The difference in the top five or six companies getting the biggest allocations is also striking. It’s interesting that the SFLNX awards Apple the biggest allocation, and under cap weighting, Apple is tied for first with Microsoft. In fact, SFLNX gives Apple almost exactly the same weight as its cap share, around 5.65%. The reason: Apple’s giant cash flow, dividends, and book value. “Apple doesn’t look all that expensive,” notes Brightman. On the other hand, the Schwab fund puts only 2.5% in Microsoft, less than half its cap footprint, since Apple’s cash flow from operations and revenues is much larger than Microsoft’s, while dividends and book value are similar. As for the Fantastic Four, Netflix, Salesforce.com, Nvidia, and Netflix, SFLNX awards them just 0.37% of its investment dollars, one-eighth their position in cap-weighted funds.

So far this year, cap-weighting competitors have far outperformed the SFLNX. It’s down 12.6%, versus a negative total return of around 5% when following the cap-weighted model. Indeed, fundamental indexing is a value strategy, and value stocks have been lagging growth stocks for a number of years.

But over history, value has a much better record, as demonstrated by the performance of its champion Warren Buffett at Berkshire Hathaway. The huge shift in concentration to those five superstars in the past couple of years, accelerated by the pandemic crisis, has made dumping that strategy more urgent than ever. The winners have broken loose of the fundamentals during the lockdown and notched record after record. The losers got pounded. It’s time to choose the formula that gets the royal share of those screaming buys.