Rethinking Those Index Funds in Your 401(k)

Many of the indexes that shape how millions of people invest — including retirement accounts such as 401(k)s — may be built on a flawed assumption: that if a stock is expensive, the company behind it must also be growing rapidly.

"But many stocks are expensive simply because they're popular, not because their companies' fundamentals justify that price," said Campbell Harvey, the J. Paul Sticht Professor at Duke University's Fuqua School of Business.

In a paper recently published in the Financial Analysts Journal, Harvey and his co-authors argue that this assumption has become embedded in many popular index funds that many of us invest in, such as those tracking the S&P 500 or the Russell 1000. As a result, many investors end up owning companies with lofty valuations but surprisingly slow business growth.

"I understand paying a high price for a company with significant growth potential," Harvey said. "But I'm not willing to pay for low growth."

The consequences extend well beyond Wall Street. More than half of all invested assets now follow passive strategies, meaning millions of retirement savers automatically own portfolios built around these indexes.

Harvey and his colleagues propose a different approach, which they call “Fundamental Growth.” Instead of defining growth by a company's stock price, they rank and weight companies using observable measures of business performance, including sales growth, gross profitability and R&D spending.

Across major developed markets, this approach outperformed traditional growth indexes by roughly one to five percentage points per year.

How today’s growth indexes are built

Millions of people invest through indexes, Harvey said. Exchange-traded funds, mutual funds and many retirement plans simply track them, giving these indexes an enormous influence on where investment dollars flow.

Traditional stock indexes are weighted by market capitalization: the larger a company's total market value, the larger its representation in the index. As a company's stock price rises relative to other stocks, its weight automatically increases.

Indexes then classify companies as either "growth" or "value."

"We usually divide the investment universe into two types of stocks," Harvey said. "One is a 'value' stock, meaning it is relatively cheap — for example, based on its price-to-earnings (P/E) ratio. Then there are 'growth' stocks, which are often expensive but offer a very high growth rate."

But Harvey argues that this process still relies too heavily on price. "Just because it's expensive, they assume it's a growth stock," he said.

The result is an unintended consequence. Companies can end up in growth portfolios largely because they are high-valuation, even if their businesses show relatively little fundamental growth. 

The problem doesn't end there, Harvey said. Most index funds also weight holdings by market capitalization.

"When you weight by market capitalization, you don't care about fundamentals," Harvey said. "All you care about is the price."

That same mechanism becomes especially powerful when large companies enter major indexes. Harvey points to recent blockbuster IPOs as an example. With companies such as SpaceX, passive funds must buy shares as soon as the company joins an index, regardless of whether its valuation reflects the fundamental value of the underlying business.

“Glamour” stocks don’t mean high performance

Harvey argues that the current system creates several distortions.

The first is what the researchers call the "glamour stock" problem. Stocks with high valuations attract even more money because they are often classified as growth stocks and receive larger weights in passive portfolios. Meanwhile, companies generating strong business growth may receive much less attention if their share prices are lower relative to their earnings or book value.

The second problem reflects how the modern economy has changed.

Traditional accounting measures like book value were developed hundreds of years ago for companies whose value came largely from physical assets such as factories and equipment. Today, many successful businesses derive much of their value from software, intellectual property, brands and innovation — known as intangible value.

Research-and-development (R&D) spending illustrates the issue. Accounting rules generally treat R&D as an expense rather than an investment, even though it often represents money spent creating future products and technologies. This expense reduces book value, Harvey said.

"But indicators like R&D growth are exactly what investors should be looking for,” he said.

Ultimately, Harvey argues, these rules affect several groups at once. Passive investors own portfolios that include expensive, low-growth stocks. Active portfolio managers often benchmark themselves against the same indexes. And innovative companies whose growth is not reflected in traditional accounting measures may receive less capital than they deserve.

A different definition of ‘growth’

The researchers' proposed solution — called the Fundamental Growth framework — begins with defining growth using business performance rather than stock prices.

"If we're going to be investing in growth, then we should look at the characteristics that define growth," Harvey said. "Things like sales growth, things like R&D growth, and things like gross profitability growth."

Instead of asking whether a company’s price-to-earnings ratio is high, the new framework asks whether the company is actually expanding its business.

To make the signal more robust, the researchers combine growth in sales, gross profits and R&D into a composite measure rather than relying on any single indicator. Companies are selected based on these observable fundamentals — not because their share prices are high.

The framework also changes how index-based portfolios are constructed.

Instead of assigning the largest weights to the most expensive companies, it allocates more weight to firms making the greatest contribution to business growth. In practical terms, if one company contributes far more to aggregate sales growth than another, it receives a larger portfolio weight regardless of which company has the higher stock price.

When the researchers tested their framework across multiple international markets (U.S., U.K., EU, Japan), the results consistently exceeded those of traditional capitalization-weighted growth portfolios, delivering annual outperformance of roughly 1 to 5 percentage points depending on the region.

Using 55 years of market data, they found their framework would leave investors more than twice as wealthy as a conventional cap-weighted index.

Passive investing and blockbuster IPOs raising the stakes

Harvey argues these questions will become increasingly important as passive investing continues to grow.

"It’s over half of all investing," he said. "In less than 10 years, it could be 80% if the historical trend continues."

As passive investing expands, more money automatically follows market capitalization. New investor dollars are allocated according to stock prices rather than business fundamentals, reinforcing the influence of the largest and most expensive companies.

The recent wave of blockbuster IPOs has amplified those dynamics.

Using SpaceX as an example, Harvey notes that passive index funds must buy shares almost immediately after inclusion in major indexes — a process similar to institutional funds’ rebalancing. With only a small fraction of shares available for public trading, those automatic purchases can temporarily push prices even higher.

"This benefits insiders and early, wealthy investors of private companies, while the retail investors are left holding the bag," he said.

Harvey also argues that if passive investing eventually dominates the market, price discovery could weaken because fewer investors will be evaluating companies based on their underlying businesses.

"At some point," he said, "markets will become dysfunctional, and in my opinion, we will swing the pendulum the other way and move back to more active investing."

“If an investor wants to invest in growth, then they should focus on the fundamental characteristics of the company.”