BofA’s Answer to a Bear Market: Outdex, Don’t Index

The S&P 500 is the pits, but for too many passive investors it is their go-to index holding. Unfortunately, that gives these folks an inferior outcome, according to Bank of America’s research group. So, investors should opt for a factor-oriented and actively managed portfolio, the researchers say.

The rap on the S&P 500 is that it is overweight, big tech stocks, even now when their prices have dived; the index is down more than 22% this year. The five biggest, led by Apple, compose almost a fifth of the S&P by valuation. And the benchmark index is a “crowded” trade, meaning many, many investors want to own it—and, as a result, it has become very volatile.

“One near-term risk that gets little airtime is crowding: Our work indicates that the S&P 500 index itself is one of the most crowded tickers in the world,” BofA contends.

A smarter alternative, argues BoA in a research paper, is to “outdex,” rather than index. That’s a catchy way of saying to construct an actively managed portfolio that uses factors to pick stocks. Its criteria for factors are sort of like the “quality” category, with a few differences.

The result is also a portfolio with a value tilt, says Ohsung Kwon, an equity strategist at Bank of America Global Research. “And value has outperformed growth since the 1920s,” he notes.

Active is doing better against passive these days, he says, although he acknowledges that passive still does the best. In other words, 37% of active portfolios outdo passive, an improvement over the 35% average over the past 10 years, he says.

While the researchers haven’t back-tested their framework on outdexing, they are confident it will do better than the traditional S&P 500 approach. Their investing criteria are:

Lower duration. This borrows a term from fixed income and means sensitivity to interest rates increases, which are happening now big-time. “Duration is at a record high now,” Kwon says. Higher rates are one reason the S&P 500, and particularly its big tech stalwarts, has been getting creamed of late.

Small leverage. The debt-laden companies will suffer a lot in an economic slowdown, Kwon says. One method to gauge the leverage level is to divide net debt by earnings before interest, taxes, depreciation and amortization (EBITDA), he suggests.

Low labor intensity. This refers to how much wages are vaulting nowadays, which do earnings no favors. This metric is calculated by dividing sales by the number of employees. The industries to avoid here are consumer discretionary and industrials, he says.

Minimal currency exposure. Thus, multinationals, which by definition have a big chunk of their sales overseas, are hurt from the strong dollar. Shun tech and materials, such as chemicals, mining and steel businesses, he says.

No crowding. Examples of these shares, which are too popular for their own good, are communications services, health care and consumer discretionary.

“Buy the most underweight stocks,” Kwon advises. “You’ll get the best alpha” over time.