The very largest stocks, supposedly the most efficiently priced market segment, may in fact be the locus of a market inefficiency. The reason: This area is surprisingly underweighted by the average money manager and its pension fund clients.
This underweighting is a key reason so many domestic equity managers and portfolios of pension funds have underperformed the market, that is, the Standard & Poor's 500 index, in at least the past four years.
As so many managers and pension funds allocate more to midsize and small stocks, their allocations on average to the largest stocks have fallen.
One manager, Twin Capital Management Inc., McMurray, Pa., and a client, Northern Trust Global Advisors, Chicago, have been trying to remedy that underweighting with a different sort of a "completeness" portfolio, although they don't use that term.
Other completeness funds often attempt to fill out portfolios with small stocks, which are underrepresented in index funds and many active core portfolios.
This portfolio tries to make up the weighting clients lack in the very largest stocks. It takes its investments from a universe of only the 50 largest capitalization stocks in the S&P 500. Twin Capital actively manages its Top 50 strategy, forming a portfolio with typically about 25 stocks.
The 50 largest stocks have produced outstanding performance in recent years. In 1998, the 50 largest stocks in market capitalization had a total return of 40.9%. No other capitalization decile of the S&P 500 came close to that return. The entire S&P 500 had a total return for the year of 28.7%.
For the four-years ended Dec. 31, the 50 largest stocks handily beat the returns of each of the other deciles in the S&P 500 as well as the entire index. For the four years, the Top 50 returned 36.2% annualized, compared with the S&P 500's 30.6%.
The Top 50 stocks made up 55% of the market capitalization of the S&P 500 as of mid-February. By contrast, as of Dec. 31, 1989, the Top 50's share was 47%.
These 50 stocks represent a big inefficiency in investment management that Twin Capital and NTGA, a manager of managers and a unit of Northern Trust Co., are trying to exploit.
With such a concentration of returns, every investor should question the efficiency of pricing of these big stocks. Many managers have contended for years these stocks are overvalued and, thus, tilted their portfolios to lower capitalization tiers of stocks.
Twin Capital now has $200 million invested in what it calls its Top 50 portfolio, according to Geoffrey Gerber, chief investment officer of Twin Capital. The money is all from NTGA, which has used the Top 50 strategy to complement the allocations of managers whose portfolios have wound up underweighting the Top 50.
William Clarkin, NTGA executive vice president, said even managers who specialize in large-cap stocks tend to underweight the 50 largest. The reason, he said, is a manager's tendency to equal-weight or non-market-weight the stocks in a portfolio.
With a track record of 21/2 years managing the strategy for Northern Trust clients, Twin Capital now hopes to interest other pension funds. Its actively managed strategy has surpassed the Top 50 passive index, as well as the S&P 500, since its inception May 1, 1997, by an annualized 129 basis points.
Pension funds and core managers risk continued underperformance unless they reconsider the collective wisdom about the so-called efficiency of the biggest stocks.