By Brett Arends
Passive investing is worsening market concentration, new research finds
Index funds are great. They give you broad exposure to the entire stock market, maximum diversification and minimal costs. Everyone should have their money in index funds, right?
That's the way of thinking today and it has a lot to offer. Low-cost index funds have generally outperformed most "active" funds, where someone tries to pick the best stocks, over time.
But if index funds are great for any individual, what happens when everyone buys them? Does everyone win?
In logic, that is called the fallacy of composition. This may be a crucial question for every investor right now: especially the general public.
And it's addressed in a new research paper written by finance professors Hao Jiang of Michigan State University, Dimitri Vayanos of the London School of Economics, and Lu Zheng of UC Irvine.
They argue that the popularity of index funds is helping to cause one of the most dangerous features of Wall Street: the S&P 500's (and the market's) massive overconcentration in a few mega-cap stocks like Apple (AAPL), Nvidia (NVDA) and Microsoft (MSFT). ).
The numbers for index funds are staggering. "In 1993," they write, "passive funds [i.e. index funds] invested in US stocks managed $23 billion in assets. This represented 3.7% of the combined assets managed by active and passive funds, and 0.44% of the US stock market. By 2021, passive assets had increased to $8.4 trillion. "That was 53% of assets and liabilities combined, and 16% of the stock market."
From 3.7% of investment fund money to 53% in 30 years.
In reality, the real change is even greater, they add. This is because many or most of the remaining "active" US mutual funds - that is, those that are still trying to pick stocks - are becoming secret indexers. They are following the indices as closely as possible. "Growth in passive investing is estimated to more than double considering the growing tendency of active funds and other investors to stay close to their benchmarks," they write.
This trend is accelerating the rise of so-called "mega-cap" companies, especially those that are likely to be "overvalued" - or at least ambitiously priced.
"Flows into passive funds disproportionately increase the stock prices of the largest companies in the economy, and especially those large companies that the market overvalues," they write. One reason is that it reduces the potential pool of active investors who may have less than the market weight in the stock, and the potential pool who may actually sell it "short," which means making an overtly negative bet on the stock. .
Even if you don't go that far, it's obvious that index funds - by definition - should invest the most dollars in stocks that are already the largest in the index and therefore the most popular.
At this point, the so-called "Magnificent Six" (Tesla appears to have disappeared from the list) alone represent about a third of the entire S&P 500 in terms of assets. If you have $100 in an S&P 500 index fund, about $32 is invested in just six companies. What do you think of diversified?
All of this makes the S&P 500 today more of a short-term trading play than a long-term investment play. As the S&P 500 rises, more people will put money into index funds. Index funds will invest your money in stocks, with most of it going into mega-caps. Stocks will go up, other people will get excited about all the money their neighbors are making and they will run out and put their money into index funds too.
"High prices attract buyers," as fund company Leuthold Group dryly notes in its latest monthly research book. Leuthold notes that even if American consumers' expectations about the U.S. economy are depressed, their expectations about stock market returns "have barely changed."
"This, at a time when the S&P 500 is trading at levels, relative to several earnings measures, associated with previous peaks like 2021, and even 2000.
This isn't necessarily an argument to sell your S&P 500 index fund: Timing these things is notoriously difficult. But it is an argument for owning mid- and small-cap stock funds, for example those that track the S&P 400 mid-cap index and the S&P 600 small-cap index, as well as one that tracks the S&P 500. Or you could do what I do. and simply invest in one that owns the same amount of each stock. Low-cost funds that do that include the Invesco S&P 500 Equal-Weight ETF RSP, which charges 0.2% annually, and the iShares MSCI USA EUSA Equal-Weight ETF, which charges 0.09%.
-Brett Arends
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06-14-24 1224ET
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