Source: Barron's
Author: Lewis Brabham

It's safe to say that John Bogle won. The founder of Vanguard Group (Vanguard Group) was mocked early in his career because he believed in a tracker$S&P 500 Index (.SPX.US)$Low-cost index funds will beat most actively managed fund managers.

Nearly 50 years after the Vanguard 500 Index Fund (Vanguard 500 Index Fund) was launched in August 1976, there is no doubt about this. In the US, the asset size of index funds surpassed actively managed funds for the first time in the first quarter of 2024. For its part, “Borg's Dumb Idea” (the nickname for Pioneer Group's original fund) has surpassed $1 trillion.

But with success comes risk. Borg died in 2019, and while he supports indexation, he also believes in diversification. This wasn't a problem for the S&P 500 index in the past, but the index has become a victim of its own success, and its most important stocks are now so sought after that they already dominate the index. They mainly come from the technology sector and account for 30% of the benchmark index.

The last time the index was so focused on tech stocks was before the internet bubble burst in 2000. Furthermore, among the seven tech giants, the three companies currently have the highest market capitalization —$Amazon (AMZN.US)$,$Meta Platforms (META.US)$und$Alphabet-A (GOOGL.US)$— Instead of being listed as a technology stock in the S&P 500 index, it is listed as a consumer and communications stock.

As a result, official tech equity underestimates the impact of the tech industry. Ben Inker (Ben Inker), GMO's co-head of asset allocation, said: “The current market concentration is far higher than any period we have experienced in more than half a century.”

That's not to say investors should sell off their S&P 500 index funds. Many experts believe that these seven companies are high quality companies, but if they want to maintain high valuations, they must continue to meet analysts' profit expectations. One of them —$Tesla (TSLA.US)$——Already in trouble due to loss of profits, its stock price fell 30% in 2024.

Includes highly respected chip makers$NVIDIA (NVDA.US)$The other 6 stocks, including them, are rising due to the market's enthusiasm for artificial intelligence. Research Affiliates Chairman Rob Arnott (Rob Arnott) said, “The person who coined the phrase 'Seven Dragons, 'apparently hasn't seen this movie because 4 out of 7 people have died at the end of the film. The argument surrounding Nvidia is that artificial intelligence will change everything. On the other hand, these companies dominate the field of artificial intelligence and will remain dominant for the next 5 to 10 years, but this isn't necessarily true in the end because they compete with each other, and new disruptors often emerge.”

However, as is the case with many investors, assuming S&P 500 funds are the main dish for your dinner investment, you should pair some appetizer funds with a good wine fund, otherwise your dinner won't be complete.

Alternatives to the S&P 500

These 18 stock funds will help you expand your investment horizons beyond the most valuable stocks and industries.

Bonds are a useful risk diversification tool — maybe the vegetable in your dinner — but many investors want to maintain a certain level of stock exposure in their asset allocation, and allocating wealth is much more difficult than it seems. For example, the popular Pioneer Comprehensive Stock Market ETF$Vanguard Total Stock Market ETF (VTI.US)$It holds 3,731 stocks, not just the biggest 500, but these thousands of small companies make up only 9% of their portfolios. The ETF's tech share weight is still 30%.

To achieve true diversification, you have to risk a different mindset. One way to do this is to look for stock funds with few or no tech stocks. Another approach is to look for funds that are less correlated with the S&P 500 index. One indicator that measures a fund's correlation is R-Squared, or R2, which reveals the extent to which a fund's price changes are determined by its benchmark. An R2 of 50 indicates a 50% correlation, and an R2 of 100 indicates a 100% correlation. Therefore, it is foreseeable that the Pioneer 500 index fund will trend the same as the S&P 500 index at 100%. (The extent to which prices change, more or less than market changes, is measured by another important statistic beta.) Meanwhile, the Pioneer Integrated Stock Market ETF has an R2 of 99, so it's not a good diversification tool.

Large-cap equity funds

Today, it's hard to find large cap funds with few or no technology stocks, and the performance of these funds surpassed the S&P 500 Index. Marshfield Opportunity is one of them.

Marshfield's R2 for the past three years was 75, which is less relevant among large cap funds. The facts also proved that it excelled in downside risk control. In 2022, when the S&P 500 index fell 18.2%, the fund actually rose 5.1%, and its five-year annualized return of 17.1% surpassed the S&P 500 index's 15.2%.

It is no accident that the word “centralized” appears in the name of this fund. Jack Shannon (Jack Shannon), a senior research analyst at Morningstar, said, “Large-cap stocks are too difficult. Only a few large-cap fund managers beat the S&P 500 without the tech giants, and they are often “super concentrated,” so you have to be very bold to build a unique investment portfolio.”

Take Marshfield, for example. The fund currently holds only 19 stocks, but they are all high-quality stocks that can withstand the sluggish market. Elise Hoffmann (Elise Hoffmann), the fund's co-investment manager, said: “We believe that to win the market in the long term, you have to be unique in some meaningful ways. We specifically look for companies that don't necessarily mimic the business cycle, which creates a very different performance model from the market.”

One of Marshfield Fund's major holdings is an insurance company$Arch Capital (ACGL.US)$ The company rose 41% when the S&P 500 index declined in 2022. Hoffman said, “Property and casualty insurance is priced according to the disaster, which does not necessarily match the economic cycle. “As insurers are in a so-called “hard market” with multiple disasters, smart insurers like Arch were able to raise their pricing during the 2022 recession while still being profitable.

Interestingly, Hoffman and her associated investment manager didn't think the “Big Seven Tech” stocks were of such high quality because the technology risked becoming obsolete. “As we evaluate, we want to figure out how long these competitive advantages will last? Co-investment manager Chad Goldberg (Chad Goldberg) said, “It's very difficult for a tech company if you want to do this. It's really hard to imagine what Apple will do in 15 years.”

Small-cap equity funds

Currently, the two main ways to diversify investments are value stocks and small-cap stocks, as both did not perform well during the tech stock bull market.

In a recent report by Matthew Bartolini (Matthew Bartolini), head of American research at SPDR at State Street Global Advisors (State Street Global Advisors), he proposed reasons for small-cap stocks and diversification of value factors, given the exaggerated influence of large-cap growth stocks in the S&P 500 index. He wrote, “Over the past 30 years, the average allocation level of 46% of S&P 500 growth stocks was more than double that of 21% of value stocks, and the average allocation of value stocks was generally the same: 31% versus 32%.” Furthermore, the index's top ten stocks had an average return of 85.6% in 2023, while the other 490 stocks had an average return of 16%. The total return of these 10 stocks accounted for 63% of the index's total return for the year, while over the past 30 years, the top 10 stocks averaged 24% of the total return of the S&P 500 index.”

The current valuation gap between small-cap value stocks and the most popular large-cap blue-chip stocks is extreme. For example, the best-performing Avantis US small cap value ETF $American Century Etf Trust Avantis U S Small Cap Value Etf Usd (AVUV.US)$The R2 is only 61, and only 5% of its portfolio is technology stocks. The average price-earnings ratio is only 10 times, and the price-earnings ratio of the S&P 500 index is 21 times.

However, in an environment of high interest rates, there is a problem with small-cap stocks, especially today. GMO's India said, “If you don't like the concentration of the S&P 500 index, it's natural to buy small-cap stocks, but we're nervous about it because one thing that happened in small-cap stocks is that these companies have been burdened with a lot of debt over the past 15 years.”

The higher the interest rate, the greater the risk they face when highly leveraged small businesses have to issue new bonds and pay heavier interest. When diversifying into small-cap stocks, it is essential to find high-quality stocks with little debt or strong enough cash flow to repay loans.

This is one reason Avantis ETF is worth investing in, as the fund emphasizes value stocks and quality stocks with strong cash flow.

Mid-Cap Value Equity Fund

However, in times of economic downturn, investors tend to sell small-cap stocks, even high-quality stocks. To increase safety, people can allocate the capital ladder upward to medium- and large-cap value stocks.

Although technically speaking,$Pacer Us Cash Cows 100 Etf (COWZ.US)$It is classified as a mid-cap stock, but it uses the method of screening the 100 stocks with the highest return on free cash flow in the large-cap Russell 1000 Index. The ETF rebalances its portfolio every quarter to get the highest returns.$Valero Energy (VLO.US)$Energy stocks currently account for 23% of Pacer's portfolio, while technology stocks only account for 9%. The fund's R2 is as low as 69, but it has outperformed the S&P 500 over the past 5 years.

Sean O'Hara (Sean O'Hara), president of the Pacer ETFs channel, said: “Three years ago, no one would say that energy was high quality. But now, it's probably the highest-quality industry; these companies are making huge profits, and the price-earnings ratio is only in single digits.”

For indexers, there is also the SPDR portfolio S&P 500 value stock ETF $Vanguard S&P 500 Value ETF (VOOV.US)$Its tech share weight is only 9%. It's a good fund, but since it's based on S&P 500 constituent stocks, and since the market capitalization of its portfolio is weighted by the largest stock in the index, its correlation with the index is surprisingly high, with an R2 of 86. Weighted ETFs such as the popular Invesco S&P 500 solve the market capitalization weighting problem by weighting each stock equally, but their technology stocks account for 15%, and the correlation is 90%.

If you prefer actively managed funds, Smead Value, Oakmark Fund, Fidelity Value Strategies, and BNY Mellon Dynamic Value have all proven to be low-tech, medium- and large-cap funds worth investing in.

Industry funds

The performance of industry funds is also different from the general market. Such funds themselves are high-risk and can be well combined with S&P 500 index funds. R2 statistics can help you find less relevant funds, but it should only be a starting point and you should consider statistics for multiple time periods.

Ben Inker, GMO's co-head of asset allocation, said, “If you use R2 and the industry for relatively short term statistical analysis, it's easy to make mistakes. But if you go back too long, you'll find that some stocks and industry changes are beyond recognition.” Based on industry relevance, Ink suggests looking back at least 10 years to cover different types of markets. People must also consider whether something has recently happened that has changed the industry.

Among stock ETFs, precious metal ETFs have the least correlation with the S&P 500 index.$Ishares Inc Msci Global Gold Miners Etf (RING.US)$The 10-year R2 is only 6 compared to the S&P 500. Other 10-year less relevant ones include S&P Utilities Select Industry Funds$Utilities Select Sector SPDR Fund (XLU.US)$,$Global X Uranium ETF (URA.US)$, First Trust Natural Gas$First Trust Natural Gas ETF (FCG.US)$and the S&P Oil and Gas Exploration and Production Fund$SPDR S&P Oil & Gas Exploration & Production ETF (XOP.US)$.

In addition to utility funds, these sector funds often benefit from inflation, which harms other sectors of the market. Gargi Chaudhuri (Gargi Chaudhuri), chief investment and portfolio strategist at BlackRock (BlackRock) America, said: “Historically, gold has played a role as a hedge against inflation, but as an investment, gold bars and gold mining stocks have performed differently. Gold mining stocks are more volatile, so it makes sense to hire an actively managed fund manager in such a high-risk industry.

First Eagle Gold is one of the best gold stock funds, and although it mainly invests in mining stocks, it also usually allocates gold. This helped stabilize earnings, and when precious metals equity funds declined by an average of 14.8% in 2022, First Eagle Gold fell only 1.6%.

Depending on the environment, utilities can be a great hedge. In times of rising interest rates like today, they face competition from high-yield bonds. However, with the economy slowing down and interest rates falling, utility companies performed well. In contrast, natural resources and energy funds performed well during the 2022 inflation spike, but did not perform well during the 2020 pandemic economic slowdown.

BlackRock America's chief investment and portfolio strategist Gaggie Chowdhury likes energy funds but doesn't like utility funds because interest rates are still high. Instead, to diversify, she advises investors to stick with investing in “lovable laggard” (lovable laggard) industries, such as healthcare and financial services, which have lagged behind the tech sector recently.

She believes that better-than-expected economic performance will support securities brokerage traders and benefit the Asus American Securities Economic Trader ETF$Ishares Trust Us Brkr-Dealers & Sec Exch (IAI.US)$. At the same time, “profit expectations are strong” for healthcare stocks. She believes that hospitals and insurance companies are in the Asus American Healthcare Provider Fund$Ishares U.S. Health Care Providers Etf (IHF.US)$It is particularly attractive. If you want to invest more widely, you can choose Ansho American Health Care Fund$Ishares U.S. Healthcare Etf (IYH.US)$.

These more popular industries weigh more than utilities and energy in the S&P 500, and they tend to be more correlated, yet they still have the benefit of diversification. Ann said that the 10-year R2 of the US Health Care Fund (iShares U.S. Healthcare) and the US Securities Economic Dealers ETF (iShares U.S. Broker-Dealers & Securities Exchanges ETF) is 65 and 62, respectively.

iShares U.S. Healthcare Providers Fund (iShares U.S. Healthcare Providers), which focuses on narrower industries, has an R2 of 49. In contrast, the S&P Oil and Gas Exploration and Production Fund$SPDR S&P Oil & Gas Exploration & Production ETF (XOP.US)$The R2 is lower at 34, while the S&P technology industry selects ETFs$The Technology Select Sector SPDR® Fund (XLK.US)$The R2 is higher at 83, which proves how the current market is driven by technology.

International funds

International stocks are a good diversification tool and should be an important part of most investors' portfolios, just like bonds. However, some country-specific investments may add additional interest. Ben Inker, co-head of asset allocation at GMO, said, “If you're looking for a market less relevant to the US, then Japan is definitely the first choice. We love Japanese small-cap stocks.”

He likes both the valuation of the Japanese stock market and the fact that the exchange rate of the yen against the US dollar is at its lowest level in decades.$WisdomTree Japan SmallCap Dividend ETF (DFJ.US)$It provides exposure to small-cap stocks, and its average price-earnings ratio is low. The 10-year R2 is 40, but you have to have real courage to risk investing in a country's small to medium cap stocks in such a remote location.

hedging

There are diversified equity funds with significant tech equity weights that still manage to maintain a low correlation with the market, and they do this through hedging.

As a large-cap fund, Central American Select Equity (Central American Select Equity) has had an unusually low R2 of 75 for the past three years, despite the recent 25% weight of technology stocks among some of the most popular Big Seven stocks. This is because fund manager James Abate (James Abate) sometimes uses put options to hedge his portfolio if the valuation is too high and the hedging costs are low.

Abbott is not tied to the tech giants. In fact, in 2022, he invested heavily in energy stocks while hedging, so his fund only fell 3%, while the S&P 500 index fell 18%. Then in 2023, he saw that companies like Meta “saw an inflection point in improving profit margins,” while the fundamentals of energy stocks deteriorated. As a result, he removed hedging and swapped energy stocks for technology stocks. Recently, he re-set up full hedging.

This extremely difficult operation is best left to professionals, but an experienced investment manager like Abbate can meet the needs of diversifying your portfolio.

Editor/Somer