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Crowded Trades

It's time to rotate out of that cap-weighted index.

It was obvious, all the signs were there, but no one saw it.

This describes all market tops, bottoms and times when a significant shift occurred. Are we at one of those times right now? You be the judge.

The shift toward passive investing is well documented and has been accelerating. Over the last decade, there has been more than $1.1T in net asset flows into passive equities. Additionally, today, passive investments represent almost 35% of all equity investments, up from 5% in the early 90s. The story that hasn’t been reported is that virtually all of that passive money is invested in capitalization-weighted products.

What does that mean?

It means that as more and more money goes into those products, the managers must buy more of the largest stocks regardless of price, valuation or earnings growth potential. Most of these are great companies to be sure, but many, by most measures, are at historically high valuations.

Why should I care?

If you recall, just a few years ago you will remember that “lost decade” from about 2000-2010 when the S&P 500 returned a little more than zero. Many prognosticators are looking for a “Trump Bump” and higher equity prices.  However, a prudent investor might ask, is there a way to participate with less risk?  I think the answer is yes.

Consider an Equal Weighted Portfolio

As you can see from the table, if you invested in an equal weighted portfolio of the S&P 500 during this period you would have enjoyed better returns with less volatility.

There have been and will be times when a capitalization weighted portfolio outperforms an equal weighted portfolio.  However, over many decades, studies have shown equal weighted portfolios have generated higher returns, often with less volatility. 

It is up to you to decide if now is the time to rotate out of your cap-weighted index into something else. To me, cap-weighted indexing feels like a crowded trade.

Christopher F. Poch, author of “Managing Your Wealth, A Must-Read for Families of Affluence,” advises private clients and family offices.

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