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Perils of Passive Investing Amid the Record Stock Market Rally

Most investors know that passively managed funds tend to outperform their actively managed counterparts over the long run. Over the past couple of decades, index funds have become ubiquitous to the point that most investors don’t take the time to understand these funds and the potential risks that may be brewing below the surface.

Let’s take a look at some of the emerging risk factors of passive investing, how they could impact investors, and how to adjust your portfolio.

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Emergence of Concentration Risk

The S&P 500 index set a record high in September 2020 despite near-record unemployment and a shaky underlying economy. Under the surface, Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Google (GOOG) comprise more than a quarter of the index’s total market capitalization, and they’re the only reason that the index is in positive territory for the year.

The concentration within the S&P 500 index stems from the fact that it’s weighted by market capitalization. In other words, larger companies account for a growing portion of the index. Many tech companies have seen their market capitalization expand relative to the rest of the market while Exxon Mobil (XOM) and other companies have experienced a contraction.

Concentration is a problem because fewer companies translate into greater volatility. While long-term investors can stomach some volatility, there are many investors in the S&P 500 and other index funds who must make periodic withdrawals, including retirement investors, pension funds or other cash flow negative individuals or funds.

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Concentrated Voting Power

The concentration of index constituents is compounded by the concentration in index issuers. BlackRock manages about $7 trillion, Vanguard manages $5.6 trillion, and State Street manages nearly $3 trillion; together they account for about 80% of all capital held in passive indexes, creating a potential issue with voting power and rights.

For instance, the three largest passively managed index funds own roughly 20% of Apple and JPMorgan Chase and an even larger percentage of smaller companies. While these issuers don’t vote as a block, they have a tremendous amount of aggregate voting power that influences large swaths of corporate America.

While the same institutional investors are the largest shareholders in both branded and generic drug makers, researchers found that generic drug companies are less likely to introduce cheaper versions of brand name drugs. These anti-competitive concerns are joined by additional concerns surrounding environmental, social, and governance issues.

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Implications for Investors

Many investors purchase index funds with the assumption that they’re buying a diversified basket of stocks, but many index funds are concentrated in a small group of companies. These concentrations tend to increase volatility and make portfolios riskier than more diversified equal weight index funds.

Retirement investors or funds that require regular cash flow may be especially disadvantaged because they are required to sell on a schedule. They cannot wait for volatility to smooth out before divesting stock, creating the potential for underperformance when invested in this type of funds. Index funds could therefore become a risk in these types of portfolios.

A final concern stems from the fact that many outperforming companies are young tech companies that have benefited from limited regulatory supervision. With the evolving socio-economic climate and an upcoming election, these dynamics could quickly change and any risk to the five largest tech companies could have a big impact on the entire S&P 500 index.

Protect Your Portfolio

There are a few steps that investors can take to protect their portfolios from these hidden risks. Before taking any action, investors should take the time to understand what they’re buying when they purchase a passive index fund. They should pay especially close attention to the sector breakdown and any concentrations in sectors or companies.

If a passively managed index fund is too concentrated, investors may want to consider purchasing an equal weight or smart beta fund as an alternative, while taking into account any differences in management fees. Investors can also build their own portfolios of stocks that have exposure to different sectors and a level of diversification that best suits them.

The issue of voting rights is a little more difficult to control. While there are actively managed ESG funds that take a stance on important issues, these funds tend to have higher management fees since they must research and reach out to companies. Some investors may see these fees as a cost of doing good, but others may not.

The Bottom Line

Most investors know that passively managed index funds tend to outperform actively managed funds over time, but there are some important trade-offs to keep in mind. Many passively managed funds have become concentrated in certain sectors or companies, reducing diversification, while a handful of issuers have commanded powerful voting rights.

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Sep 09, 2020