Dangers of Passive Index Investments

With investors becoming more aware of costs and expenses, many have decided to move to passive index investments. This move has allowed investors to reduce costs and obtain returns similar to the index. Passive investments or index funds can be great if used correctly and for the right person/situation. For example, a younger person who is contributing to their 401k and has a long time horizon is a great candidate. They can easily endure the ups and downs of the markets while dollar-cost averaging over their working life. For someone who is already retired or approaching retirement an index fund may not be the best option. The risk for a retiree/near-retiree is that they could hinder the longevity of their retirement capital since an index fund, by design, will match the index in both good and bad markets. A related risk involves an investor’s behavior especially during a down market. Please refer to our previous blogs about Sequence of Return Risk and Investor Behavior Gap to better understand these risks. 

Many investors do not realize the hidden dangers of investing in index funds. When it comes to indexes like the S&P 500, most of the passive funds are market-cap weighted - meaning that large companies like Apple make up a sizable portion of the index fund’s holdings. These companies have become so highly valued that the five largest companies (Apple, Microsoft, Alphabet (Google), Amazon, Facebook), account for 17.5% of the market-cap weighted S&P 500 Index. This is inconsistent with the whole idea of buying a cheap, broadly diversified index since just five technology-based stocks will have such a significant impact on the index’s performance.  To put this in perspective, as recently as 2012 the top 10 holdings in the index accounted for approximately 20% of it’s value and contained more than just technology stocks (names like Walmart, Exxon, and Pfizer). 

As a result of how they are structured, an index fund overweights stocks that have outperformed while underweighting those that have underperformed. The more those big five stocks go up the more the index funds have to buy them.  An investor that prefers to buy low and sell high will be forced to watch the exact opposite happen within their index fund. An investor is betting that whatever has been going up will continue to go up. History tells us that is a bad bet.  While growth stocks, like the technology companies mentioned above, have been the leaders for most of the past decade, history shows that rotations from growth stocks to value stocks will not be announced and can result in vast performance differences. The last time growth-oriented technology stocks substantially outperformed value-oriented stocks was in the 1990’s.  The following decade value stocks dramatically outperformed growth stocks.  

As with all things in life there are positives and negatives related to investing in passive index funds. Low costs and market matching performance work to an investor’s benefit especially during the accumulation phase of their financial lives.  That same market matching performance during the distribution phase of an investor’s financial life may work against them especially when the next bear market hits.