Why Index Funds Are Actually Expensive

Know what you’re buying. Whether we’re talking about a stock, an ETF, or an index fund, you’ve got to really know what you’re buying. Because if you don’t, you won’t understand why it’s not performing the way it should be.

Take an ETF like the United States Natural Gas Fund (NYSE: UNG). It’s supposed to track the price of natural gas sold in the U.S. If you thought natural gas was going to rally, well, this would sound like an ideal way to play it. But if natural gas actually did rally, you might not make very much by owning this fund. In reality, it doesn’t track the price of natural gas very well at all. 

That’s because it uses futures to track nat gas prices. If you don’t know, futures are contracts that allow commodity players to buy and sell particular commodities in the future at a price that gets set today. So if you are a farmer, you can sell your whole corn crop right now at a pre-determined price by selling corn futures. Of course, the buyer will pay a little more to lock in a price for the future, because the future is uncertain. This is known as time value — after all, time is money. 

For the buyer, time can be the enemy. Because a futures contract will lose some value as time passes. That’s why the US Nat Gas Fund doesn’t work like people think. The fund buys futures, and then as time passes, it sells those futures and buys more that are dated further into the future. If nat gas prices don’t go up, the fund loses some money when it sells the futures it bought. Then it has to pay more for new futures. Over time, the fund loses value because it’s poorly conceived.

Or what if you were bullish on China and bought the iShares China Large-Cap ETF (NYSE: FXI)? Did you know 10% of that fund is in Tencent Holdings? Sure, it’s a $200 billion company. But so is Alibaba (NYSE: BABA), and it is not even in the top 10 holdings of this ETF.

The iShares Nasdaq Biotechnology ETF (NASDAQ: IBB) is a popular way to trade biotech. But it’s not a pure play — 14% of this ETF is devoted to pharma stocks like Merck and Pfizer. The two biggest holdings are Amgen and Gilead — around 17% of the fund is invested in these two. But overall, there are 189 stocks in IBB.

The Market Vectors Biotech ETF (NYSE: BBH) is much more concentrated — nearly 25% of its holdings are in Gilead and Amgen, with another 15% in Celgene and Biogen. That’s 40% of the fund in just four stocks. 

None of these stats make one fund better than another. But they are pretty different. And that could come as a surprise if one of those big holdings in BBH has a problem. 

Know Your Index Fund

It’s the same way with index funds, believe it or not. Index funds like the S&P 500 SPDR (NYSE: SPY) have gotten hugely popular. The fees are very low. They are diversified, and the performance has been great. Between 2011 and 2014, the SPY averaged 11% gains. No mutual fund or hedge fund manager can duplicate those gains, so why pay extra?

But here’s the thing; 20% of the SPY is in just 10 stocks: Apple, Exxon, Microsoft, J&J, GE, Amazon, Facebook, Berkshire Hathaway B shares, AT&T, and JP Morgan.

Think about that for a second. When you buy the S&P 500 ETF, you are buying Apple, Microsoft, Facebook, and Amazon. There are huge questions with each of these stocks. Apple revenues are actually declining. Will Facebook be worth $325 billion this time next year? Is Amazon expensive with a forward P/E of 72? What if Microsoft’s $26 billion purchase of LinkedIn doesn’t go well? 

Personally, I don’t worry about Amazon and Microsoft so much. But I do have concerns about Apple and Facebook, at least at their current valuations. 

Here are some more stats about the S&P 500 I picked up from Bloomberg:

• The top 100 stocks in the S&P 500 represent 64% of the index. The next 100 account for an additional 17%, and the remaining 300 account for just 19% of the index.

• The average price-to-earnings ratio of those 100 stocks is 34 (using one-year trailing earnings as of the most recent fiscal year). The average P/E ratio of the next 100 stocks is 27. And the average P/E ratios of the last three groups of 100 stocks are 25, 25, and 23, respectively.

• In 2011 the average P/E ratio of the top 100 stocks in the index was 20, while the average P/E ratio of the next four groups of 100 stocks was 20, 22, 27, and 24, respectively.

I find these facts and figures really interesting. Basically what they are saying is that the vast majority of gains that have come on the S&P 500 have come from the 100 biggest stocks. Those are the ones whose P/E ratios have changed the most. The other 300 to 400 stocks have not seen their valuations change really at all. 

Do You Feel Lucky?

One of the strong selling points of an S&P 500 index fund is that you are buying a good representation of the market. You will be diversified and enjoy steady long-term gains because the S&P 500 carries a reasonable valuation of around a 22 P/E ratio (the SPY actually says its P/E is 19, but that doesn’t sound right). 

The reality is that you are buying the 100 biggest companies, and they are not cheap at all. 

So I thought it would be fun to run a screen for P/E ratios on the S&P 500 and see what we find (yeah, that’s actually fun for me). Finviz.com is a very useful free website you can use for this. 

The first screen I ran was for stocks on the S&P 500 with a P/E over 30. There are 120 of them. That’s too many, so I narrowed the field by adding “+5% earnings per share this year” to the screen criteria. There were 44 results, which I can work with. (Though please note this means there are 76 stocks on the S&P 500 with P/Es over 30 that won’t even grow earnings by 5% this year. That… is not very good.)

Right on the first page of screen results was chipmaker Broadcom (NASDAQ: AVGO), sporting a P/E of 205. Crazy expensive, right? Well, not so fast. Broadcom is the result of a 2015 merger between Broadcom and Avago. It might be the best chip company in the world. The merger has doubled revenue, which will hit $13 billion this year and $16 billion next year. The forward P/E based on analyst expectations is 12. And it pays a 1.3% dividend. This stock is actually cheap. 

Thirteen real estate investment trusts (REITs) made my screen. Out of 44 stocks, that seems like a very high percentage. And a few of them look pretty expensive. 

Now, as the editor of The Wealth Advisory dividend/income newsletter, I love REITs. They can have great yields of 5% and higher and predictable revenue.

But both Avalonbay (NYSE: AVB) and Federal Realty (NYSE: FRT) have fairly low yields at 3% and 2.3%, respectively. And their forward P/Es are 20 and 25 — which doesn’t imply significant earnings growth. 

Now, expensive dividend stocks are one of the results of the Fed’s low interest rate policy. Investors are paying a premium to get some dividend yield. I would say, in the case of AVB and FRT, they are paying too much. 

One of my favorite REITs has a forward P/E of just 10, and it pays a sweet 10% dividend. It’s around $28 a share, and I have a $40 price target on it. 

I don’t know how REITs will react when the Fed gets serious about raising interest rates. But that time seems pretty far in the future.

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.