The short version
- Index investing allows investors to easily diversify their portfolios in a passive and often cost-efficient way.
- However, some indexes are market-weighted based on their market cap. Meaning, the index gives greater weight to certain companies.
- For example, in the case of the S&P 500, the top 10 companies make up 29.3% of the entire index and all but two are tech companies.
- Potential index investors should be aware of this market weighing before they decide if they want to invest in an index or diversify their holdings elsewhere.
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How index investing works
As the name implies, these passive investment vehicles will always track, in an automated way, an underlying index. While the most famous of these are the passive index funds that track major equity indices such as the Nasdaq and the S&P 500, there are a huge variety to choose from. There are index funds for bonds, commodities and even emerging markets.
As an investor, you can simply look one up through your broker and choose the one that is the most attractive. Sometimes there will be different providers who offer the same underlying index to track. However, they may charge different fees, or hold different weightings. We will touch on this later in the article.
While once upon a time index funds existed as mutual funds, nowadays it is much more common to use ETFs for passive index investing. These ETFs have their own ticker symbol. They are listed on major indices, and trade daily just like a regular stock. The benefit is that they have similar liquidity to stock, allowing investors to buy and sell throughout the trading day. This gives them a major advantage in simplicity over traditional mutual funds.
When an investor has found the index fund that they would like to invest in, they simply buy its “shares” through their broker. The fund manager (for example, Vanguard or Charles Schwab) receives that money and spreads out across all the companies in the index, at the same weightings that the index holds. These fund managers charge a management fee. It's commonly lower than 0.1% per year for passive index funds. This makes them a great low-cost and simple way to track an index. Due to the management fee, these funds will never track the index perfectly. And they will always have a lag that equates to the management fee that the fund charges. This lag is another reason to always go for a passive index fund with as low a fee as possible.
Find out more: What is an ETF?
Index investing as a long-term investing strategy
Once an investor has started investing in their passive index fund, the general strategy is to use dollar cost averaging over the long term. This means investing a constant amount periodically, regardless of what the market is doing.
In this way, investors have the best chance of avoiding getting in at the absolute top of the market, and can better absorb any monthly market shocks. Investors avoid market timing and can get the long-term returns expected of the stock index. For example, the S&P has a long term return of 10%-11% per year, but this includes years of significant drawdowns such as the great financial crisis and the corona crash.
Many financial advisors recommend investors to passively index invest due to the efficient market hypothesis. This theory states that all possible available information is already priced into a stock and, as such, it is impossible for an investor to have an edge by investing in specific stocks. It follows that any outperformance is impossible over time, due to luck or due to excessive risk taking (or all three!). While this theory has its critics, many believe and follow it as well.
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Is index investing really as diverse as it seems?
The main benefit to pursuing an index investing strategy over an actively managed strategy is diversification. With the S&P 500 index fund, your money is being split over 500 different companies. This significantly reduces the chance of an issue with a single company tanking your portfolio.
Compare that to someone who invests in 12 stocks. If we assume an equal weighting to each, any huge drop in a stock will impact 8.3% of your portfolio. If multiple stocks in your concentrated portfolio are related by product or by sector, then all the related stocks will likely go down as well. Just like that, a problem with one stock can wreak havoc on an entire portfolio.
The above sounds great in theory, but is it really true?
Many investors buy into index investing because of the above claim, however these same investors should be aware of some acute risks that often get overlooked when focusing on the built-in diversification argument.
For one, if there is a serious marketwide crash, expect that no amount of diversification is going to help you, unless you are diversified into uncorrelated assets such as bonds or commodities. During the Great Recession, despite holding 500 of the largest businesses in America, the S&P 500 still dropped a whopping 50%.
Additionally, not all indexes are created equal. Some, despite being market indices, are still decently correlated. For example, the Dow Jones 30 tracks, you guessed it, only 30 stocks. On the opposite end of the spectrum, the Russell 1000 tracks 1,000 small to medium cap American stocks.
But the biggest risk to investors is that, in many cases, individual companies have an outsized impact on the index that it is part of.
Why index investing is really just investing in big tech
Looking into this, we are going to use the S&P 500 as our example, as it is possibly the most popular index for passive investors. Many people prefer the S&P 500 over the Nasdaq100, another major American index, due to the heavy concentration of tech companies on the Nasdaq.
This is solid logic. However, if we look at the S&P 500, we will find that the index is market-weighted. This means that each member of the index isn’t given an equal weighting within the index, but instead is given a weighting based on the company’s market cap. As such, the larger you are as the company, the larger your weighting in the index and therefore the larger an impact you have on the index as a whole.
If we look at what the largest cap stocks on the S&P 500 are, we see some familiar names in the top five spots: Microsoft, Apple, Amazon, Tesla, and Google. As we can see, the largest weighting of the index goes exclusively to tech companies. In fact, the top 10 largest companies of the index have a total weighting of 29.3% of the entire index, and only two of the companies are not in tech (and are at the bottom of the ten in terms of size).
There is a legitimate argument to be made that these are massive companies and that tech is the future. It makes sense for them to take up such a large proportion of the index. That may be true, but it hides a very significant risk to investors who believe that they have a different kind of diversification when they invest in indexes.
Investors who put their retirement savings or their IRA into an S&P 500 aren’t really investing in 500 different companies. They are investing a big chunk into tech names, with some other sectors tacked on. If this index was equal-weighted, Microsoft’s performance should have a 0.002% impact on your returns. The reality, however, is that Microsoft currently has a 6.4% impact on the index’s returns.
This is already a big issue when one company can have such an outsized effect. When all the largest constituents are in the same sector, this brings a deeper and more dangerous risk: these companies are relatively correlated to each other.
The table above shows a correlation matrix between Apple, Microsoft, Tesla and Google. They may not be too correlated individually. But as a group there is certainly an above average correlation to each other's movements.
Not only is this a risk investors need to be aware of, but the structure of these indexes can lead to painful drawdowns. As index investing has exploded in popularity over the last decade, we see more and more money pouring into index tracking funds. These funds take each dollar it receives and divides it according to market cap. This creates a feedback loop where the majority of each new dollar invested goes into these large tech companies, because they are the largest. As these index funds buy more of their shares however, they grow larger and larger. As they get larger they suck up more dollars from each new dollar invested, and the cycle continues.
The risk here is what happens when the trend reverses in a significant bear market? Likely, many investors will sell their index fund holding in order to hold cash or go into bonds. As a response, these funds will have to sell their holdings, and will have to sell their largest holdings first. We could very well see a negative feedback loop occur in this situation.
How to use index funds to create diversity in your portfolio
The above might be giving off the wrong impression — index investing isn't bad. It's just important to understand the nature of the risks that index investing has, especially related to tech investments. In fact, if you were undecided between tracking the S&P 500 and the Nasdaq, perhaps now you will feel more comfortable investing in the S&P 500 after seeing what a heavy tech lean it has.
There are also ways to counteract the structural issues and risks that index investing presents. The simplest of which is to invest in an index fund that tracks your chosen index in an equally weighted manner rather than market cap-weighted. Each holding in the index would have the same weighting. As such, there would not be any skew to the largest companies. Keep in mind that you would no longer be tracking the index in a perfect way, but your investment would be much more diversified. It is also important to note that these funds tend to have higher management fees associated with them as well.
Finally, you can diversify into multiple, different index funds to get diversity across your holdings. There are index funds for various kinds of asset allocation such as government bonds, corporate bonds, gold and oil. There are also international stock indexes you can track to give you further diversity from American markets. For example UK, Japanese or Chinese index funds. And there are even index funds focusing exclusively on emerging markets. These tend to be less correlated to developed market indexes.
Find out more: How to diversify your investment portfolio
The bottom line: Should investors still index invest?
If you don't want the headache of actively managing your portfolio and researching individual stocks, you are almost certainly better off investing into an index for the long term. After all, there is a reason Warren Buffett recommends it.
The biggest danger to investors isn’t a market drop, it is the unknowns — things that happened that the investor had no idea could happen. Investors should always know exactly what they are investing in and what it means for their portfolio.
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