WHEN just about everybody is using index funds to invest in the stock market, maybe you should think about thinking differently.
Over the 12 months ended Oct. 31, investors withdrew $218 billion from U.S. equity funds run by active stock pickers, while adding $273 billion to passive market-tracking mutual funds and exchange-traded funds, according to Morningstar.
With more and more shares in the hands of people buying them regardless of whether they are cheap, the stock market feels increasingly unmoored from the classic bargain-hunter’s credo of “buy low, sell high.” Many analysts and fund managers worry that this automated market could drive stocks to perilous heights.
However, the evidence that index funds are responsible for driving up stock prices is surprisingly thin. Active mutual funds own nearly twice as much of the shares of hot companies like Alphabet, Amazon.com and Facebook as passive funds do, according to FactSet. What’s more, bitcoin is up more than 50% in a week, and index funds are nowhere to be found in the explosive runup of the digital currency.
So it’s far from certain that passive funds are as dangerous as their critics contend.
Still, even if you keep most of your money in index funds, you may well buy a few stocks on the side. According to the Federal Reserve, 13.9% of households directly owned shares in at least one stock in 2016, up slightly from three years earlier.
Even Burton Malkiel, the Princeton University economist whose 1973 book, “A Random Walk Down Wall Street,” spelled out the case for index funds, has put “a quarter to a third” of his money in individual stocks — if only “because it’s fun.”
An academic study found in 2008 that wealthier individual investors who directly owned only one or two stocks outperformed those who are more diversified by about two percentage points annually — and up to nearly six percentage points when the stocks weren’t in the S&P 500.
So, instead of just buying Amazon.com or Apple, you might consider putting a small amount of money into “orphan stocks” that aren’t held by index funds.
A company can be orphaned for several reasons, says Michael Venuto, co-founder of Toroso Investments, a research and asset-management firm in New York.
It might no longer have enough stock outstanding to accommodate large investors. Some companies’ shares have limited voting rights. A spinoff, carved out of a larger firm, often hasn’t yet attracted a following.At S&P 500 companies, index funds hold an average of 17.4% of outstanding shares, according to FactSet; in the Russell 3000 index, encompassing thousands of smaller stocks, index funds hold an average of 16.2%.
Yet passive funds hold less than 5% of outstanding shares at 311 companies in the Russell 3000. Among those under-owned by index funds: Daily Journal, International Game Technology, Lennar’s Class B shares, Maui Land & Pineapple, Pilgrim’s Pride, Southern Copper, Speedway Motorsports and Viacom’s Class A shares.
What’s more, most index funds and ETFs shun stocks with total market values below $100 million; many don’t touch anything smaller than $250 million. Such so-called microcap stocks trade too thinly for most big funds to own them.
An index fund of stocks not owned by any other index funds doesn’t appear to exist, although it probably wouldn’t be a bad investment idea.
“The companies that aren’t in the ETFs have absolutely been abandoned,” says Jim Boucherat, a portfolio manager at Pacific View Asset Management in New York, which oversees more than $70 million in microcap stocks.
He says many microcaps are trading close to book value and often for as little as four times the cash their businesses generate — fractions of what the stocks favored by index funds sell for.
Owning microcap stocks is not for the chicken-hearted.
In 2008, the smallest 10% of U.S. stocks lost 43.7%, including dividends, while the biggest tenth lost 35.5%, according to data from Dartmouth College finance professor Kenneth French. The next year, the tiniest U.S. stocks gained 45.3%, while the biggest went up 24.3%.
So far this year, microcaps have underperformed megacaps by nearly 7.5 percentage points.
Overall, since 1926, microcaps have outperformed the biggest stocks by an average of more than three percentage points annually — although some of that would have been eaten up by higher trading costs.
In a speech in 1963, the great investor Benjamin Graham said that “a minority of investors” can “get significantly better results than the average.”
Graham added, “Their method of operation must be basically different from that of the majority of security buyers. They have to cut themselves off from the general public and put themselves into a special category.”
The bigger and more popular index funds become, the harder that is. For investors who can be picky and patient, it might also turn out to be more lucrative. - WSJ
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