a close-up of a screen by Anne Nygård courtesy of Unsplash.

Risks of Indexing in Today's Market

Bill Rautiola |
Categories
Invest

Investors have historically fared quite well by not overcomplicating their investments and simply buying an index, such as the S&P 500. This has particularly held true over the last several years, with the S&P 500 posting a total return of over 100% in the past five years. There is no denying that this method has worked - and lately, it has worked tremendously well. As Vanguard founder John Bogle famously said, “Don’t look for the needle in the haystack. Just buy the haystack!”

What is Indexing?

An index is a group of securities designed to track a particular segment of the financial markets. For example:

  • The S&P 500 tracks the performance of 500 of the largest U.S.-based companies.
  • The Dow Jones Industrial Average tracks 30 prominent U.S. companies.
  • The Russell 2000 tracks 2,000 small-cap U.S. companies.

With the inception and rapid popularization of mutual funds and index funds, it has become easier than ever to purchase a fund that aims to track the holdings of a particular index (with a near-zero management fee). 

This is the concept of indexing; purchasing a fund that simply tracks a major index. An investor simply “Buys the market”, rather than attempting to beat the market through purchasing individual securities.

The results speak for themselves. Over the past century, the S&P 500 has delivered average annual returns of about 10%, and real returns (after inflation) close to 7%.

Warren Buffett, who ironically has managed to beat the market handily over his tenure managing Berkshire Hathaway, famously made (and won) a million-dollar bet. The bet was that the S&P 500 index would outperform a group of hedge funds over a decade. Buffet was right, and won the bet, proving that simply buying the index can be the best option for many investors.

Index ETFs have seen tremendous inflows over the last couple of decades. More money than ever is simply parked in index funds, rather than attempting to beat the market. This popularity, however, has created hidden risks that investors should be aware of.

Risks of Index Investing Today

Most indices, such as the S&P 500, are market-cap weighted. Put simply, this means that the larger companies take up a bigger share of the index and influence the price movement much more than the smaller companies in the index. 

Today, due to the strong financial positions and current bull run among the mega-cap tech companies involved in the AI trend, the top ten companies in the S&P 500 comprise over 40% of the S&P 500. This concentration has surpassed levels seen in the dot-com bubble in the early 2000s. While today’s market is not identical to that period, the takeaway is that the S&P 500 is far less diversified than many investors may assume. 

Although you are technically purchasing little slices of 500 companies, almost half of your investment is tied up in just 10 companies. The takeaway is that the future performance of the S&P 500 will be heavily dictated by the performance of a few mega-cap stocks such as Apple, Microsoft and Nvidia.

On top of this, many of these large companies are trading at historically high valuations, leaving less margin for error if market sentiment sours.

How to Protect Your Portfolio

In today’s market, it is as important as ever to construct a well-diversified portfolio that looks beyond headline indices. In general, you should aim for a portfolio that is

  • Invested across different asset classes (Stocks, Bonds, Alternatives).
  • Diversified across regions (Domestic and International).
  • Taking advantage of sectoral and thematic trends.

Take the time to look under the hood of your portfolio to truly understand your positioning. Despite high valuations, there are still many opportunities across many sectors, regions, and asset classes.

As always, I recommend reviewing your portfolio with a trusted financial advisor to ensure that it aligns with your long-term goals.

-Bill Rautiola, RICP ®, AIF ®, PPC ®

 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Stock investing includes risks, including fluctuating prices and loss of principal.​ Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.