Is Passive Investing in Index Funds a Recipe for Danger if the Market Corrects?

When you look for stocks to own, most investors do research to find the best growth or reasonable value, perhaps the best products or best management. If we look at the widest index fund being used right now, the S&P500, and break down what exposures you have to a market correction, you will see the highest valuations and arguably the ones at most risk in the equity market make up the largest positions in the index. The largest 5 stocks make up 12% to 13% of the whole index. The names of those 5 stocks are Apple, Alphabet (Google), Microsoft, Amazon and Facebook. All technology related stocks. (In the interest of honesty, it can be noted that Johnson & Johnson is actually the # 5 stock and Alphabet is not, due to Alphabet splitting its share classes into A & C. The index owns both and combined that puts them at #2, dropping J&J to #6). Out of 500 companies in the S&P 500, 5 companies are a driving force to the direction of the index.

Many people like to own a few stocks. Are you one that owns one of these most widely held stocks only to have the rest of your “diversification” in an S&P index fund?

Let’s look at another index fund that is widely held, the Vanguard Large Cap Index Fund or even the Vanguard Total Market index fund. The largest positions in both of those funds are the same 5 that top the S&P 500.  These stocks are not being owned because someone deemed them the best stocks to own. They are owned in the largest proportion to the funds because they are the largest companies out there. It’s called “Cap” weighted or Capitalized Value. The only consideration in owning these stocks in an index fund is because they are big companies. That’s it.  Index funds are a valuable part of the investment world, but understand what you own. The bottom line is based on the weightings, if one or more of these large stocks corrects, so will most of your investment and there is no way to avoid it in index funds.

By Greg St. John, Exec. Vice President