Hidden risks of index funds: What investors should know
Index funds are often touted as one of the best ways to invest for the long-term and for good reason. They can offer instant diversification at low costs and largely outperform active funds over the long run.
But as a smaller number of companies, called the “Magnificent Seven”, have come to dominate the stock market and the indices that track it, some are questioning whether passively managed index funds are truly passive.
Here’s what you need to know about index funds and the hidden risks your portfolio may be exposed to.
Passive investing and index funds: How it works
The idea behind passive investing is that it is pointless to try to do better than the market averages over time, so the best course of action is to keep your costs low and broadly diversify your holdings. The invention of index funds made it easy to invest based on market indices such as the S&P 500.
Rather than try to identify which stocks will do well or poorly, index funds invest solely based on the underlying indices that they track. So if a company comprises 3 percent of the S&P 500, that’s how much an S&P 500 index fund will invest in it as well.
Because the S&P 500, and many other stock market indices, are market-cap weighted, the largest companies make up the largest weights in the index and in the funds that track them. Recently, this has created some challenges, as seven large companies have vastly outperformed the broader market and grown to account for a large portion of index fund portfolios.
The “Magnificent Seven” stocks and index funds
Since the start of 2023, seven stocks have come to dominate the major market indexes due to their strong outperformance. Apple, the largest company in the S&P 500, has a market cap that is nearly 6 times that of the 10th largest company, UnitedHealth Group (UNH), as of October 2023.
| Company | Ticker | Market cap | YTD return as of 10/18/23 |
|---|---|---|---|
| *Market cap data as of October 18, 2023. | |||
| Apple | AAPL | $2.8 trillion | 36.9 percent |
| Microsoft | MSFT | $2.5 trillion | 43.9 percent |
| Alphabet | GOOG/GOOGL | $1.8 trillion | 62.8 percent |
| Amazon | AMZN | $1.4 trillion | 56.5 percent |
| Nvidia | NVDA | $1.1 trillion | 200.7 percent |
| Tesla | TSLA | $808.9 billion | 106.9 percent |
| Meta Platforms | META | $815.6 billion | 169.2 percent |
As the stocks of the largest companies in the S&P 500 have surged this year, much of the rest of the index have failed to keep pace, which causes the “Magnificent Seven” to account for even more of the index. These seven stocks make up about 28 percent of the S&P 500 as of October 2023, up from 20 percent at the start of the year.
Investors in S&P 500 index funds may not be getting what they’re looking for in a fund, says Nick Ryder, chief investment officer at Philadelphia-area wealth manager Kathmere Capital Management. These investors are typically looking for broad diversification and contribution from many different stocks, but instead they’re inherently making a bet on these seven companies, he says.
The impact on the Nasdaq 100 Index was so pronounced that a special rebalancing of the index took place over the summer to avoid violating diversification rules for the funds that track the index. The seven tech giants accounted for more than 60 percent of the index before the rebalancing took place.
| Fund | Ticker | % of fund in “Magnificent Seven” | Date of holdings |
|---|---|---|---|
| Vanguard S&P 500 ETF | VOO | 27.4 percent | 9/30/23 |
| SPDR S&P 500 ETF Trust | SPY | 28.8 percent | 10/17/23 |
| Invesco QQQ ETF | QQQ | 43.7 percent | 10/17/23 |
| Fidelity Nasdaq Composite Index Fund | FNCMX | 48.7 percent | 9/30/23 |
| Shelton Nasdaq-100 Index Fund | NASDX | 43.1 percent | 9/30/23 |
Ryder says that enthusiasm about artificial intelligence is partially responsible for the outperformance of the largest stocks, while adding that investing based on narratives can be dangerous for investors.
“The problem with narratives is that they tend to be fully reflected in stock prices,” Ryder says.
Index fund alternatives
Investors looking to limit their exposure to the “Magnificent Seven” stocks, while still taking an index-based approach, have a few options.
The first alternative would be to buy an equal-weighted S&P 500 index fund. As the name implies, an equal-weighted fund holds stocks in equal weights, regardless of their underlying market caps. So a $1 trillion company is held in the same proportion as a $50 billion company. You’ll still have exposure to the seven largest companies, but it will be dramatically lower than a standard S&P 500 index fund.
Another choice would be to buy value-based funds, such as funds that invest based on metrics like the price-earnings ratio. These funds invest in stocks that appear cheap based on quantitative metrics. The “Magnificent Seven” stocks largely come with premium valuations, so value funds may hold them in reduced weights or not at all.
In Kathmere client portfolios, Ryder says they’re trying to mitigate the impact of the seven largest companies by making thoughtful adjustments to the S&P 500, while acknowledging it’s difficult to outperform a market-cap weighted index over the long-term.
“We’re just taking the overall S&P 500 and tilting toward things that are cheap on fundamentals, and away from things that are expensive based on fundamentals,” Ryder said. “It’s not an either-or decision, it’s about trying to balance the risks.”
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
