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Investing Specialist in investment modeling focusing and robo-advising You May Be More Into FANG/FANMAG Stocks Than You Realize 1,657 views | May 27, 2020, 10:30am EDT Marc Gerstein Contributor It’s been said time and again that one of the advantages of owning shares of an ETF is the one-trade access it provides to a diversified portfolio. Whether the ETF is oriented toward an asset class, a region, a line of business or a general combination of these, we should at least be expecting the ETF to be implementing a “top-down” view of some sort of defined “market” and spare us the burden of obsessing over the unique — idiosyncratic — characteristics of specific securities. Be careful, though, about ETFs that are, in fact, requiring investors to do the exact thing they assume they don’t have to do: company/stock-specific research.

Market commentators often speak about breadth, measuring it through indicators like advancing issues versus decliners. When a rally is described as having poor breadth, it usually indicates that the market’s strength relies on a small number of very strong stocks, while most others perform only adequately or worse. This can lead individual investors to feel less like failures if the market rises but their portfolio underperforms, attributing the underperformance to broader market dynamics rather than personal investment choices.

The term FANG refers to Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOGL); with the inclusion of Microsoft (MSFT) and Apple (AAPL), it broadens to FANMAG. This group has significant influence on market performance, especially in large-cap indices. The FANMAG stocks tend to dominate market movements because of their size and growth, leading to a portfolio bias heavily weighted toward these stocks, often at the expense of diversification.

Fundamentally, the approach to investing in FANMAG stocks suggests a model in which a portfolio is constructed to favor these companies. The logic is that these companies are the economy or are at least representative of it, making a strong case for their dominance within index-based portfolios. The model follows rules such as: Buy if not in the portfolio and in FANMAG; hold if in the portfolio and in FANMAG; sell if in the portfolio but not in FANMAG; ignore otherwise. This systematic, rule-based strategy posits that past performance of these stocks indicates future prospects, but this assumption warrants caution given the risks of overexposure to top-heavy portfolios.

Such focused stock selection relies heavily on the FANMAG factor, which has contributed strongly to recent market outperformance. However, critics argue that this approach elevates risk because of concentration and market dependence on a few key players. Diversification becomes challenging when a large portion of the market’s returns is driven by a handful of companies, risking a potential bubble or sharp correction if these stocks decline.

Historical data show that many ETFs and indices are heavily influenced by these stocks due to their market capitalization weighting. For example, ETFs like SPY and IWB are top-heavy with FANMAG components, accounting for a significant proportion of the holdings. This concentration leads to a phenomenon of “shadow momentum,” where rising prices of these large stocks feed into the index performance, often independent of underlying economic fundamentals. Consequently, the returns of passive ETFs can become skewed toward the performance of a few stocks, undermining the diversification benefit.

The reliance on market cap weighting amplifies the concentration risk, as large stocks tend to outperform during bullish phases and drag during downturns. The compounding effect of price increases in top stocks can lead to inertia, further driving their prominence within indices and ETFs. This inertia results from the mathematical weighting process: as a stock’s price rises, its market cap and, thus, its weight in an index increase, reinforcing its influence. Conversely, declines diminish a stock’s weighting, leading to an increased volatility focus on a few stocks.

Some investors criticize this approach, advocating for alternative weighting strategies such as equal weightings (RSP) to mitigate concentration. Equal weight ETFs allocate the same weight to each component regardless of size, reducing the dominant influence of FANMAG-like stocks and promoting more diversification. However, these strategies may also involve different risks, such as increased volatility or tracking error.

In conclusion, while the FANMAG stocks have propelled index returns and market growth, their outsized influence raises concerns about over-reliance on a narrow segment of the market. Investors should recognize the risks associated with top-heavy portfolios and consider diversification strategies that temper concentration. Moreover, active stock selection, fundamental analysis, and tailored portfolio strategies can help manage systemic risks associated with sector and stock-specific volatilities. As market dynamics evolve, adaptive approaches that balance growth potential with risk mitigation will be key to sustainable investment success.

Sample Paper For Above instruction

In the realm of investment modeling and robo-advising, understanding the influence of dominant stocks like FANMAG (Facebook, Amazon, Netflix, Microsoft, Apple, and Google) is crucial for constructing resilient portfolios. Recent market trends have showcased the outsized impact these tech giants have on broad market indices, largely due to their significant market capitalization. A focused approach that emphasizes FANMAG stocks can yield impressive backtested results, but it carries inherent risks associated with concentration and systemic vulnerability.

The prominence of FANMAG stocks in market indices like the S&P 500 results partly from the market cap-weighted construction of these indices. As these stocks increase in price, their weight within the index correspondingly increases, amplifying their influence on overall index performance. This phenomenon, described as inertia or shadow momentum, can lead to a substantial skew in portfolio returns, heavily favoring a small subset of stocks. Consequently, investors exposed primarily to such indices may unknowingly accept significant concentration risk, making their portfolios vulnerable to sector-specific downturns.

Beyond market cap weightings, the reliance on passive ETFs like SPY or IWB, which hold hundreds or thousands of stocks, does not necessarily guarantee diversification. The top holdings often consist predominantly of FANMAG stocks, explaining why these funds can perform well during market rallies driven by these stocks. However, this top-heavy structure means that declines in FANMAG stocks can disproportionately impact the ETF’s performance, negating the benefit of broad diversification.

To address these issues, investors and portfolio managers might consider alternative weighting strategies such as equal weight ETFs (e.g., RSP). Equal weighting reduces the influence of the largest stocks, offering a more balanced exposure to the broader market. Such an approach can dampen the inertia effect but may introduce higher volatility and tracking risk. Balancing the trade-offs requires a thorough understanding of market dynamics and investment goals.

Active stock selection strategies further mitigate concentration risks by incorporating fundamental or technical analysis, emphasizing stock-specific factors over broad market movements. For instance, a strategy that actively seeks undervalued or high growth potential stocks outside the FANMAG group can diversify exposure and reduce systemic risk. These strategies leverage detailed company analysis, including earnings growth, valuation ratios, and technical indicators, to construct a portfolio resilient to sector-specific shocks.

Fundamentally, understanding the composition and construction of market indices and ETFs is vital in managing exposure to concentration risk. Market cap weighting, while efficient for liquidity and scalability, amplifies systemic vulnerabilities, especially in indices dominated by a few large companies. Investors would do well to critically evaluate their exposure, possibly incorporating equal-weighted funds, fundamental factors, or active management strategies.

In conclusion, although FANMAG stocks have driven significant market gains, their outsized influence underscores the need for diversified, risk-aware investment strategies. Active management, alternative weighting schemes, and a thorough understanding of index construction are essential tools for investors seeking stability amid rapid technological and market shifts. By adopting such approaches, investors can better navigate potential downturns and enhance long-term portfolio resilience in a complex, rapidly evolving market environment.

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