Active Management Can Help Avoid Overvalued Companies

With large-cap stocks remaining the major driving factor for the market, investors should be wary about their levels of concentrated company exposure and consider active management.

A recent research paper, Passive Investing and the Rise of Mega-Firms, explores the relationship between passive investing strategies and how they affect the valuations of the world’s largest firms. In short, the paper argues that passive fund flows can disproportionately affect the stock price for large-cap companies. This is especially the case for companies that the market current is overvaluing.

“Passive investing thus reduces primarily the financing costs of the largest firms. This makes the size distribution of firms more skewed,” the paper added.

Research-Based Approach

While the paper serves as a cautionary tale for some large-cap passive strategies, an actively managed ETF could avoid some of these pitfalls. The T. Rowe Price U.S. Equity Research ETF (TSPA) uses an actively managed, research-based approach that can proactively navigate overvalued large-cap securities.

TSPA aims to provide investors with access to long-term capital growth. To do so, the fund invests in large-cap stocks to create a core equity portfolio similar to the S&P 500 Index, but where the holdings are selected by highly specialized industry research analysts.

The fund uses an active portfolio oversight team to curate a portfolio similar to sector and industry weighting to the index. This strategy helps the ETF maintain similar economic exposure of the index, but without being locked into the same individual holdings.