3 Hidden Dangers of Index Investing

August 13, 2020
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In 1975, Jack Bogle wanted to offer the average investor a way to achieve market returns without paying a steep fee to a fund manager[i]. Thus, index investing, and investment manager behemoth Vanguard, was born. Bogle initially conceived his idea as a mutual fund but about half of all index investing is now done with the use of Exchange Traded Funds (ETF).

                Put simply, index investing is the strategy of buying all of the holdings of an index (like the S&P 500 for example) in order to closely track the performance of that index. The strategy aims to get the return of the market without active trading and the associated fee of an investment manager. As previously stated, about half of all index trading is now done through ETFs which often have very low management fees and are allowed to trade intraday as opposed to mutual funds which only trade at market close and often have much higher management fees[ii].

                If that sounds like a good strategy, you are not alone! In 2018, index funds saw an influx of over $458 billion in new assets. This is a trend that will likely continue into the 2020s so what, if anything, are the risks associated with this kind of investing[iii]?

 

Six Stocks

                One of the arguments in favor of index investing is the inherent diversification that comes from owning all of the holdings in an index. Except that is not exactly true. Index funds, like the indexes that they aim to replicate, are market cap weighted. Meaning, the larger the company’s value, the greater percentage of the index’s return they represent. This can be problematic when investing in a fund that tracks an index like the S&P 500. Such funds may in fact be investing about 25% of your dollars [iv]in only six stocks all of which are in the technology sector. This means then that the S&P 500 Index (and the funds tracking it) is skewed towards technology and thus heavily impacted by news regarding this sector which has recently become one of intense scrutiny by regulators. While none of these companies or the technology sector in general are an inherently poor investment, this is an important consideration when building a well-balanced portfolio.

 

Anti-Trust Concerns

                You would be forgiven for thinking that the mass migration to index funds is purely individual investors seeking market returns with low fees. After all, that was the original intent of the strategy as its founder envisioned it! The truth, however, is a bit more complicated. For context, three fund companies hold 80% of all indexed money: BlackRock, Vanguard, and State Street. Collectively, they hold about $15.5 trillion in assets under management. While they also run actively managed funds, a large portion of their holdings are in indexed ETFs. The result is a concentration of shareholder voting power in the “Big Three” fund companies. Collectively, they own about 22% of the average S&P 500 company in their portfolios. In addition, only about a 6th of index fund investments are from individual investors, the rest being from large corporations and institutions[v]. This gives the Big Three significant sway over some of the largest companies in the U.S. economy. Despite the Big Three’s assurances that they will not use their influence to affect public policy, there are those who are urging them to support their social and political agendas. Others are concerned that such common ownership will cause a reduction in competition that could affect American consumers negatively. After all, if you own shares in two drug companies for example, you do not really want them to get in a price war with each other. These concerns have begun to attract the attention of regulators and it is likely that we will see changes down the line.

 

Market Volatility

                Of a more personal nature is the inherent volatility associated with an index fund. As previously stated, the purpose of an index is to ‘get what the market gives’. This means riding all of the highs and lows of the market. If you are young and a long way off from retirement, this probably isn’t a problem. Indexing was designed to be a buy and hold strategy, not a get rich quick scheme. However, if you are either approaching retirement or already in retirement, then an index fund is probably not for you. Market volatility, especially in retirement, can have a dramatic, sometimes devastating impact on your portfolio. As you near retirement, your investment strategy should shift from aggressive growth to more moderate investments including bonds, annuities, and other types of fixed income strategies. Keeping your investments in an index fund leading up to retirement could potentially put your funds at risk for sharp drops in the market that could disrupt your retirement plans.

 

Conclusion

                As with any investment strategy, it is important to examine your own personal situation when considering your options. Index investing has it’s benefits but it also isn’t the “silver bullet” that many make it out to be. As always, discuss your options with your financial advisor to see if index investing is suitable strategy for your situation.

[i]https://www.cnbc.com/2019/01/16/bogle-changed-investing-with-index-funds-but-wasnt-always-happy-about-it.html

[ii]https://www.investopedia.com/terms/i/index-investing.asp

[iii] https://www.investopedia.com/terms/i/index-investing.asp

[iv]https://www.marketwatch.com/story/the-hidden-risk-hiding-in-your-sp-500-index-fund-2020-07-17

[v]https://www.bloomberg.com/news/features/2020-01-09/the-hidden-dangers-of-the-great-index-fund-takeover

 

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. An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.