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You may already own the meme stocks — here's how to fix that

It was easy to get caught up in the hype around so-called meme stocks over the past six months. The story, after all, has all the markers of a movie, but those who watched from the sidelines, and knew not to buy a ticket, may have unintentionally made the meme stocks a blockbuster hit.

That's because many investors owned the stocks through the index funds in their investment and retirement accounts. By employing technology, advisors can ensure that their clients steer clear of these blunders. 

The distorting effect of meme stocks

Each year, the FTSE Russell, which serves as a benchmark for $16 trillion in assets, rebalances the holdings in its family of indexes, a move that, according to Russell, looks to "strike a reasonable balance between accurate representation and cost." The process involves adding and removing stocks to reflect current market conditions and meet the index’s objective. 

Normally the shake-up draws considerable attention. Fund managers mark their calendars for the event and know to expect a day of heavy trading volume. But this year stood out even more: the annual reshuffling paved the way for meme stocks, SPACs, and other trendy assets to enter the mammoth index funds. 

What we saw was GameStop, previously a significant component of the Russell small-cap value index, become a large-cap stock. AMC, which many expected would join GameStop, remained a small-cap stock, and a slew of other buzzy names were added and removed from the Russell universe. 

At first glance, this may seem odd. GameStop is now in the same group as Facebook and Walmart, and AMC is now one of the largest small caps around. 

Indeed, the labels might not mean much anymore, but it does have major implications for the funds that hold these names. Take AMC, for example. The movie chain is now the largest holding in the iShares Russell 2000 Value ETF, even though it doesn't fall under the broad definition of value, often characterized by a low price-to-book ratio. Those who bought the $15 billion ETF, thinking that they were investing in value, might have bought something else altogether. 

The iShares ETF is not alone. Before the June rebalancing, Invesco S&P SmallCap Value with Momentum ETF held 8.8% of the fund in GameStop, far outweighing any individual name in the fund. 

Some elements of this drift are inevitable and even beneficial. The surge in GameStop shares helped the Invesco ETF jump 41% year-to-date, perhaps far higher than where it would have gone otherwise. Other times the drift can be misleading and even detrimental. Some investors may want to take advantage of a fund as it was designed. The outsized exposure to these volatile assets only leaves them vulnerable to losses when the rally inevitably ends. 

How to prevent the shake-up

Most passive ETFs have no other option but to let meme stocks grow (or shrink) as a holding. Some argue that the benchmark could rebalance more frequently than annually, and that would solve the problem. 

Research from Dimensional Fund Advisors agrees, "daily portfolio management can potentially spare investors from style drift." It prevents investors from deviating from their target allocation and allows them to focus on their goals rather than short-term events. But as the same research suggests, "daily rebalancing would likely be prohibitively expensive for a strategy rigidly tracking an index." In other words, ETFs are hard to change unless the benchmark changes. 

This, however, doesn't need to be the case. Modern wealth-tech now lets advisors rebalance a client's portfolio as frequently or infrequently as they see fit. And thanks to zero-commission trading, it won't cost $5 per trade. The benefit is that advisors have a mechanism to reduce exposure to meme stocks or other volatile assets that have moved too quickly. 

What's more, these tools—like direct indexing, custom indexing, and more advanced single stock investment strategies—can unbundle an ETF altogether. Each approach, at its most basic level, allows investors to own individual stocks rather than the funds that may hold them. By doing so, advisors can build portfolios that better satisfy a client's needs, whether they want to remove AMC from the small-cap portion of their portfolio or they want a portfolio designed from the ground up. 

It means advisors no longer have to worry about the next GameStop or next AMC derailing their client's portfolio. The technology handles that automatically.

July 23, 2021