Are the Largest Stocks the Most Overvalued?

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Opponents of passive, index-based investing frequently claim that large-cap stocks are overvalued, and a market-cap-weighted index unduly exposes investors to those mispriced securities. That is a false statement.

As chief research officer for Buckingham Wealth Partners, I have often been asked about the claim by Robert Arnott, Jason Hsu and Philip Moore, authors of the paper, “Fundamental Indexation,” that “capitalization weighting assuredly gives additional weight to stocks that are currently overpriced relative to their (unknowable) discounted future cash flows (the true fair value), and reduces weights in stocks that are currently trading below that true fair value. This leads to a natural performance drag in capitalization-weighted and other price weighted portfolios.” This argument has been used as a criticism of total market-cap funds and other index and systematic strategies that use market-cap weighting.

Is that claim correct?

If the largest stocks are the most overvalued, we should see: 1) greater persistence of active managers in large stocks than in small stocks, and 2) anomalies to asset pricing models are greater in large than small stocks.

For evidence on the persistence of performance of active managers, we can turn to Standard & Poor’s 2021 SPIVA Active Versus Passive Scorecard.

SPIVA results

While just 6% of U.S. active small-cap funds outperformed their risk-adjusted benchmarks over the 20-year period ending in 2021, an even smaller 4% of active U.S. large-cap funds beat their benchmarks. If the largest stocks were the most mispriced, we should see evidence of that in greater levels of outperformance by active managers exploiting the mispricings, especially since larger stocks have lower trading costs, reducing the hurdles to generating alpha. Yet, we saw that the opposite was true. Large-cap funds showed lower percentages of outperformance over one-, three-, five- and 10-year periods as well. The average (equal weighted) active large-cap fund underperformed the S&P 500 by 1.68 percentage points over the 20-year period. On an asset-weighted basis, the underperformance was 1.10 percentage points.