What’s Bubbling Up? The Hidden Costs of Indexing

Investors eager for “safety” have been piling into indexed portfolios at the expense of actively managed strategies—and thus making a big, and risky, bet against deep value and for high-dividend  yielding stocks.  We think they’re pursuing just the wrong course.

We see significant opportunity for outsize returns in deep-value stocks and an unusually high degree of downside risk in the high-dividend payers.

You can see the opportunity by comparing the weight of the two groups within the S&P 500. Outperformance by stocks paying high dividends has driven their index weight to a record high: almost 45% of the index’s market capitalization is in stocks with a dividend yield 20% or more higher than the index, as the display below shows. At the same time, underperformance has driven down the weight of low-price-to-book stocks. Roughly 25% of the S&P 500’s market cap lies in stocks with a price/book ratio 20% or more below the market P/B. That’s even less than during the tech bubble!

Low-PB and High-YIeld Stocks' Market Weights Have Diverged Dramatically

Since 1970, the median market cap of the two groups has been similar: 34% for high-dividend payers, and 31% for the low-price-to-book group. If the mix normalizes—as it has historically—low-price-to-book stocks will outperform and high-dividend payers will underperform. Investors in the index could be slammed two ways.

Deep-value stocks have outperformed the market significantly over time, with large bursts in outperformance following prior periods when poor performance drove down their market weight. In the 12 months after earlier low points in their index weight, low-price-to-book stocks have outperformed the market handsomely: by 3.8 percentage points in the 12 months after August 1978, by 12.7 points after October 1990, by 7.5 points after December 2000, and by 10.3 points after November 2008. And indeed, the gap in market weights between low-price-to-book and high-dividend yield stocks wasn’t as wide at those points as it is today.

If we assume a relatively conservative 10% future outperformance by low-price/book and 10% underperformance by high-dividend paying stocks, index investors may be leaving almost 200 basis points annually on the table, owing to the biased construction of the S&P 500 today.

And we estimate that a portfolio with exposures to high-yield and deep-value stocks close to the historical average could outperform the S&P 500 by as much as 15%.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Vadim Zlotnikov

Chief Market Strategist; Co-Head—Multi-Asset Solutions; Chief Investment Officer—Systematic and Index Strategies
Vadim Zlotnikov is Chief Market Strategist, Co-Head of Multi-Asset Solutions and Chief Investment Officer for Systematic and Index Strategies. As Chief Market Strategist, he provides macro and quantitative research that helps identify thematic investment opportunities. As Co-Head of Multi-Asset Solutions, Zlotnikov manages the development and implementation of integrated investment portfolios for the retirement, institutional and retail markets. As CIO for Systematic and Index Strategies, he is responsible for ensuring that individual products meet investment objectives. Zlotnikov served as CIO of Growth Equities from 2008 to 2010. From 2002 to 2008, he was chief investment strategist, responsible for developing portfolio recommendations for the US market and for separate quantitative analysis and money-management research products. Prior to that, he was an analyst covering the PC and semiconductor industries; he launched the technology strategy product in 1996. Before joining the firm in 1992, Zlotnikov spent six years as a management consultant with Booz Allen Hamilton, where he conducted a broad range of strategic and operational studies for technology companies. He also worked for Amoco Technology Company as a director of electronic ventures and spent two years as a research engineer with AT&T Bell Laboratories. He has been named to the Institutional Investor All-America Research Team in the semiconductor components, strategy and quantitative research categories. Zlotnikov holds a BS and an MS in electrical engineering from the Massachusetts Institute of Technology and an MBA from Stanford University. Location: New York

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