What’s Bubbling Up? The Hidden Costs of Indexing

October 22, 2012

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.
-Vadim Zlotnikov, chief market strategist, AllianceBernstein

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!

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