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Why Low-Cost Index Investing Is Not Necessarily Low Risk

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A handful of tech stocks, which together account for about 15% of the market weight of the S&P 500, are responsible for almost all of the index’s gains year to date. They’re also the reason the Nasdaq has gained close to three times as much as the S&P 500 so far this year: up 13.2% compared with 4.8%.

This top-heavy index performance, due to six stocks — Amazon, Microsoft, Apple, Facebook, Alphabet (Google’s A shares) and Google (Google’s C shares) — presents a huge concentration risk for investors that few appreciate, says Robert Sharps, head of investments and group chief investment officer at T. Rowe Price.

“Such narrow leadership has benefited passive strategies, but there are alpha cycles,” says Sharps, referring to cycles when active management can outperform.

“Active managers can do well when there’s breadth in the market, not when it’s dominated by a handful of large names, which is the environment we’re in…. Passive is beta exposure at very low cost … not lower risk.”

Asked about data showing that actively managed funds have generally underperformed their passive counterparts over 3, 5, 10 and even 15 years, Sharps admits that active management in the current bull market “has not been great, not even good,” which was also the case in the last downturn.

“It will be really important for many active managers to do better in the next downturn.”

(Related: Don’t Expect Active Funds to Outperform in a Bear Market)

Many active managers argue that active funds are more likely to outperform in a bear market, and intellectually that makes sense. Active managers can be nimble, take advantage of market dislocations and hold more cash — actions that index managers can’t take.

Passive funds are “fully exposed to market risk” and their investors are “married to the market for better or for worse until liquidation do they part,” says Ben Johnson, director of global ETF Research at Morningstar.

But passive funds continue to grow in popularity. According to Morningstar, one-year net flows into passive U.S. mutual funds and ETFs through the end of May totaled $577.08 billion compared to $2.88 billion into active U.S. mutual funds and ETFs. Passive U.S. equity funds experienced net inflows of $174.7 billion through the end of May, while their active counterparts saw net outflows of $195.5 billion.

The inflow into passive funds isn’t surprising given the continuation of the bull market and the funds’ lower fees, but what happens when the bull market ends?

“How many passive investors that own the index will have the fortitude to not panic and sell their index funds?” asks Christopher P. Bloomstran, president and chief investment officer of Semper Augustus Investments Group LLC, an RIA based in Denver and St. Louis, which takes a value approach for actively managed concentrated equity portfolios. (It’s named after the most expensive tulip sold during the Dutch tulip mania in the 1600s.)

“Today is not unlike 1999, a dangerous time to be investing in a market index fund,” says Bloomstran.

1999 was the year before the dot-com crash. From their peaks in early 2000 to their troughs in late 2002, the S&P lost close to 50% of its value and the Nasdaq plummeted 80%.

Bloomstran’s client letter shows what happened to the stocks with the heaviest weightings in the S&P 500 in mid-July 1999 years after the dot-com crash. Like now, the top six stocks constituted 15% of the index weight: Microsoft, GE, IBM, Walmart, Cisco Systems and Lucent Technologies. From July 12, 1999, to Dec. 29, 2017, the annual return of the top five (Lucent doesn’t exist as a standalone company anymore) ranged from a negative 1.1% for GE to 5% for Walmart. The annual return of the S&P 500 during that time was 4.5%.

“How many investors, particularly those invested in index funds, would have predicted these results over the next 18-½ years?” asks the letter.

Bloomstran says index investors now should “prepare for what stands to be mediocre to poor returns over a very long period of time. …The two tenets that matter to good investors — business quality and price — can’t be controlled in an index fund.”

Johnson agrees that when the market reverses “owning the market outright may not look as good.” He says he has “no idea what will do better” when the market turns, but low-volatility, quality-oriented strategies such as the Vanguard Dividend Appreciation Index Fund Investor Shares (VDAIX) and iShares Edge MSCI Min Vol USA ETF (USMV) and iShares Edge MSCI USA Quality Factor ETF will likely fare better in the next bear market.

Indexing, however, is the not the biggest risk, according to Johnson. “The biggest risk of all is us,” he says, referring to potential panic selling. “Ultimately the best strategy for investors is the one they’re most likely to stick with.”

— Check out Index Funds Are Going to Be Just Fine on ThinkAdvisor.


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