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The Growing Danger of Index Funds

A professional risk analyst says investors with S&P 500 index funds and ETFs may not realize the added risk they're now taking

By Rick Bookstaber

Diversification is the most powerful concept in finance. By holding many stocks, you can substantially reduce the portfolio's risk. When some stocks are going up in value, others might be going down. A market event — say a rise in oil prices — will drop some stocks, but it will increase the value of others and leave yet other stocks largely unaffected.

A Wall Street Trader on the trading floor. Next Avenue, index funds, ETFs, S&P 500
Credit: Brendan McDermid/REUTERS/PBS

This is why investors are encouraged to hold portfolios of many stocks, and why so many Exchange-Traded Funds (ETFs) and mutual funds hold dozens, if not hundreds, of stocks drawn from a wide set of sectors and industries. After all, by the time you have 500 stocks in your portfolio through an S&P 500 ETF or index fund, surely you are just about as diversified as you can be, right?

In principle, this is correct. In reality, it is not and it's why S&P 500 investors are taking more risk than they probably realize. If you have money in a pension fund or 401(k), or your IRA is in a set of broad-market ETFs or funds, you are holding something closely aligned with the S&P 500.

How S&P 500 Funds and ETFs Work

The problem is that while the S&P 500 holds many stocks, it does not hold a small amount of each stock.

The problem is that while the S&P 500 holds many stocks, it does not hold a small amount of each stock.

Obviously if you hold, say, 500 stocks but 90% of your money is in just one of them, you are not going to get much benefit of diversification. While not quite that dramatic, something similar is what occurs with most indices, including the S&P 500 ETFs and funds.

This occurs because the rule for how much of a stock an S&P index ETF or fund holds is based on its market capitalization: the dollar price of a share multiplied by the number of shares it has outstanding. It's basically the market value of the company.

For example, Apple has 16 billion shares and each share is currently worth $150, so Apple has a market capitalization of $2.4 trillion. By comparison, Ford has a $55 billion market capitalization. So, if your portfolio holds the S&P 500, you'll have 50 times the dollar investment in Apple as you do in Ford.

As the market stands today, this is a big problem for diversification, because the largest stocks have much higher capitalization than the other stocks. In fact, the top 10 stocks in the S&P 500 now have 25% of that index's weight in terms of capitalization; the tech sector comprises 40%.

The Tech Tilt in the S&P 500

If 40% of your portfolio is in technology and tech-sector shares overall drop by 50%, your portfolio would be down by 20% — actually probably 30% or more, since other positions would be affected, too.

This tech tilt in the S&P is at a historic high. The only time it came close was in 2000 and things did not end well that time around. Then, the S&P 500 fell nearly 50%, partly because the dot-com bubble in tech, telecom and media stocks violently burst.

A graph showing S&P 500 Technology exposure. Next Avenue, index funds, ETFs, S&P 500
Credit: Courtesy of Syntax Affinity

A chief reason for the growing significance of tech in the S&P 500 is the domination of companies where scale matters, perhaps even where a natural monopoly exists. When you hold an S&P 500 ETF or fund, you are highly concentrated in these stocks — most notably Apple, Google, Facebook, Microsoft and Amazon. So, if something bad happens in the tech sector, your S&P portfolio will be highly affected.

Put another way, without even knowing it, you have placed a big bet on technology.


How to Lower Your Risk

On Tuesday, Sept. 28, the S&P 500 fell 2%, its worst one-day drop since May, partly due to the slide of 3.5% or more for companies like Facebook, Google and Microsoft. By contrast, the Dow dropped 1.6%. Until recently, the S&P had been up for seven straight months.

The solution for increasing diversification without taking on the extra risk of an S&P ETF or fund is to find an ETF that is spread well across economic sectors, country exposures and what are called styles, such as large companies versus small companies.

The message is simple: You are not getting the diversification you might be expecting from the broad range of ETFs and funds that mimic the standard indices.

Equal-weighted ETFs are offered by companies such as Syntax, iShares and TOBAM; the latter is French and works with institutional investors such as pension funds; it doesn't offer ETFs.

The message is simple: You are not getting the diversification you might be expecting from the broad range of ETFs and funds that mimic the standard indices. This not only goes for the S&P 500, but for others like the suite of Russell indices and the international MSCI ACWI index.

So, if you're in an S&P 500 ETF or fund, you may want to look instead to one using an equally weighted index. At a minimum, don't add tech ETFs or funds to your portfolio because you already essentially have them in the mix, even without trying.

Rick Bookstaber
Rick Bookstaber is co-founder and head of risk at Fabric, a firm focused on risk management for financial advisers. He previously held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates and the University of California. At the U.S. Department of Treasury during the Obama administration, he helped steer the risk management process and governance for the U.S. financial system post-2008. Read More
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