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The Myth of Index Investing For Diversification

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The Myth of Index Investing For Diversification

One of the common investing beliefs is that index investing – buying exposure to an entire index like the S&P 500 through a single investment – provides an extra layer of safety through diversification.

On the surface, it makes sense. Take the S&P 500 for example. With the SPDR S&P 500 ETF Trust (SPY), you are buying into a basket of 500 companies, and so in theory you are spreading out your risk over all those companies.

But what many investors overlook is how the index is weighted toward a handful of companies. This means your return is mostly based on the performance of just a few companies.

The Top 10 Holdings’ Impact

For the SPY ETF, the top 10 holdings account for 26.86% of the total assets. The remaining 490 companies account for 73.14% of the total assets.

And out of those top 10 holdings, Microsoft makes up a full 6% of the ETF’s total assets. Meanwhile, Apple makes up 5.78% and Amazon is 4.49%. So, just three companies account for 16.27% of the ETF.

Think about how that skews your returns. For every $1 you invest in the SPY, $0.26 is riding on the performance of just 10 companies.

Those companies can do well in instances similar to this recent bull market rally. When it does, it can keep the overall index floating along despite what the “other” 490 companies are doing.

As Brett Arends points out in a recent MarketWatch column, since the March 23 lows, 30% of the S&P 500’s gains have come from just six stocks.

“Since the brief market euphoria peaked early last month, for example, casino stocks have fallen 18% on average, department stores 19%, hotels, resorts and cruise lines 25%, and airlines 28%, according to market data provider FactSet. American Airlines has fallen 40%, United 35% and Southwest 18%. MGM Resorts has lost a third of its value. Carnival, another 40%. Macy’s is down another 30%.”

Plunges Started During the Recent Rally

Arends points out that those massive plunges aren’t since the initial market dive in February, but since the recent rally.

“Those aren’t the stock falls since the crisis began in late February. These are the declines just since the early June “recovery” rally. Measured from the start of the year their declines in many cases are catastrophic,” said Arends.

“The notion that equity indexes are somehow risk-free states has to my mind always been a dangerous fallacy which has been amplified by the rise of passive investing,” said Mark Urquhart, a money manager at Baillie Gifford. “Actually, all three of the significant market crises which my career has contained—technology, media and telecoms (TMT), the financial crisis and now the coronavirus—have been linked by so much damage being done to particular parts of the index that it demolishes the thesis that index investing can diversify away such risk.”

Economist Robert Shiller, a Nobel prize winner, points out that right now S&P 500 index is valued at 30 times the average per-share earnings of the past decade. The index has only matched or exceeded that level twice since records began in the 1880s: In 2000, and 1929. Both of those instances preceded a significant market crash.

If you are looking for true diversification with an index fund and you don’t want just 10 holdings making up 26% of a fund’s assets, consider an equal-weighting index fund or ETF. With an equal-weighted fund, each holding is the same amount of the overall fund.

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