“The Magnificent Seven” term has transcended its cinematic roots to become the collective moniker for a select group of U.S. mega-cap stocks responsible for over 90% of the S&P 500^®’s YTD gains to October’s end. Their stellar performance has, naturally, elevated their valuations. It has also increased their already-hefty collective weight in the equity benchmark. Some might be wondering whether, rather than slavishly sticking to capitalization weights, is it now time to adopt an active approach, taking profits and avoiding further concentration?Sharp rises in stock prices have been somewhat frequent historically, even among the market’s relative giants. Unfortunately, such occasions do not appear to present easy ways to outperform—at least judging by the collective evidence of 20 years of S&P DJI’s SPIVA^® Scorecards. But even if the time is right to sell, many investors holding positions in the “Magnificent Seven” will have made a profit on them. Over and above any potential regret for their haste, selling out may invite another unwelcome consequence: a tax bill.Recently, we published a major extension to the traditional SPIVA library with the first SPIVA After-Tax Scorecard. The report shows that, to put it bluntly: taxes matter. For example, Exhibit 1 (reproduced from the report) shows the impact of taxes on three-year underperformance rates by actively managed broad U.S. equity funds through December 2022.
Is it different this time? The current situation is not unusual. In most recent years, the top seven contributors¹ ended the year looking relatively expensive (see Exhibit 2). A particularly intriguing comparison is seen in 2017. At that time, the so-called “FAANGs” faced a similar degree of market skepticism, with P/E ratios averaging nearly three times that of the index itself.
As it turned out: the seven top contributors in 2017 went on to contribute nearly 40% of the S&P 500’s 9.9% annualized return from December 2017 through October 2023. Five of them (including four of the FAANGs) are in today’s Magnificent Seven.If it were simple to know when to sell seemingly overvalued stocks (as well as when to buy undervalued ones), actively managed funds might boast a better record. The inclusion of tax considerations only makes the evidence more emphatic. And while individual tax circumstances differ, the SPIVA After-Tax Scorecard highlights that taxes could have made a significant impact on the average returns of actively managed U.S. equity funds. They also show that, in recent times, the task of selecting an outperforming active fund net of poorly timed trades, fees and taxes was almost (if not completely) impossible.¹ We recognize that 7 is somewhat arbitrary; why not 6 or 8? For the sake of consistency and with a nod to the contemporary discourse, we stick with the top 7 contributors in each historical period and their trailing P/E ratios at that time.More By This Author:Measuring Fixed Income Opportunities In Asia With Indices Material Change In A Material World Tracking The Evolving Yield Landscape With Indices