Are You Underweight FANMAG? Chillax!

Key Points

  • The anti-value, momentum-driven, narrowly concentrated rally in the first half of 2017 has been hostile for strategies that apply a value and rebalancing orientation to a broadly diversified universe.
  • The RAFI strategies do not emphasize the most popular stocks, such as today’s FANMAG stocks—Facebook, Apple, Netflix, Microsoft, Amazon, and Google—but do have a track record of producing long-term excess returns.
  • Our research suggests that popular, pricey stocks have low odds of outperforming in the long run, even if they are shares of large, growing, and profitable companies.
  • We encourage investors—especially in times like these when a handful of stocks have captured the public’s imagination—to have conviction in a time-tested, value-oriented, contra-trading philosophy.

The first half of 2017 is shaping up to be unequivocally brutal for value-oriented rebalancing strategies. Wired to avoid pain, we humans know it’s very tempting to ask whether a model or philosophy is broken, especially the moment it dashes expectations.1 When distress afflicts us, our instinctive response is “Get me outta here!” Perhaps, instead, we should consider a less conventional approach as advised by John’s nine-year-old daughter to her occasionally stressed-out dad: “CHILLAX!”

A mixture of the words “chill out” and “relax,” to chillax, according to the Merriam-Webster Dictionary, means to calm down. For John, chillaxing means watching movies on Netflix and Apple TV or searching for latest sports stats on Google News. For Amie, shopping on Amazon, doing yoga on Microsoft Xbox, or browsing her Facebook newsfeed usually does the trick. While embracing these activities usually soothes our nerves, underweighting the stocks of these six companies—FANMAG2—has rattled our portfolios. With all but one surging by more than 25%,3 these six stocks have collectively led the stock market rally of 2017.

Chillax to the Max
As we approach the second half of the year, the rally’s breadth, according to some, is narrowing to levels not seen since the tech bubble. Such an environment tends to be horrific for strategies, such as the RAFI Indices, that apply a value and rebalancing orientation to a broadly diversified universe. It’s no easy feat to ignore the discomfort and angst that follow underperformance, even when the rational side of our brains persistently lectures us that 1) such outcomes are to be expected in these conditions and 2) extrapolating the past into the future is one of the biggest sources of investor error (Arnott et al. [2016] and Arnott, Beck, and Kalesnik [2016a,b]).

Many of our readers will not be surprised that RAFI strategies consistently underweight contemporary high-flyers, such as today’s FANMAG.4 In light of their structural positioning, won’t the RAFI portfolios fail to emphasize these very popular stocks currently outperforming the market? Of course! But despite interim periods of short-term underperformance, the RAFI strategies have a track record of producing long-term excess returns.5

In the current hype-filled marketplace, investors can too easily forget the long-term value proposition of contra-trading: trimming the expensive darlings with, on average, lousy forward-looking returns, while rebalancing into the unloved stocks with, on average, attractive prospective returns. This rebalancing engine embedded in the RAFI Fundamental strategies is what ultimately drives our long-term excess returns. But these excess returns can only be captured by investors who are able to chillax during the inevitable short-term bouts of adversity. Chillaxing is much easier said than done.