The debate between active vs. passive investing has been raging on for decades. The majority of the time, passive tends to be the winner in that debate, with some notable exceptions. The truth, however, is that both win at different times. Typically, in times of crisis, active investing tends to be your friend. Being more selective with the stocks you buy during times of strife can help mitigate downturns in the market.
In my opinion, now is definitely one of those times when you want to be very cautious about being in all passive investments. Recent run-ups in technology companies have created tremendous opportunities for investors. Names like Nvidia, Intel, and Micron, just to name a few, have exploded recently. While that has been great for those who own them, the danger is that as of now, the top 10 companies in the S&P 500 make up almost 40% of the total index. We are seeing this play out internationally as well. Only three companies in the MSCI Emerging Market Index make up 29% of the total value. When concentration levels are this high, only a few companies having a down day can make the entire index drop, even if many stocks are up for the day. This is a danger of passive investing. Indexes are not as diversified as they once were due to a few companies representing such a large portion of the overall index.
What does this mean to investors? For starters, the risk level you thought you were at is likely much higher as a result of concentration. Portfolios that were once considered “growth” are now more like “aggressive growth” as a result of a handful of companies making up such a large percentage of the index. Today’s concentration level is the highest we have seen in 60 years, since the mid-’60s. This isn’t to say that these companies won’t continue to do well in the future, but simply to point out that high concentration levels can lead to higher risk. Stocks that dominate today may not in the future. According to Capital Group, in the 1980s oil and gas stocks made up 29% of the market cap, and today they represent about 3%. Similarly, at that time, Japan made up 44% of the MSCI World Index vs. only 3% today. The translation is that what dominates today might not in the future, and investors may want to emphasize true diversification to potentially reduce risk levels.
An index is designed to track a benchmark, not to identify risk levels with that benchmark or whether or not those assets are overvalued or undervalued. If you still want to hold passive index investments during these concentrated times, then consider an “equal weight” index instead of a market-weighted index like most investors are currently invested in.
The next year or so may show that careful security selection may win out of traditional passive market-weighted indexes. Either way, it is important for investors to recognize the current environment surrounding indexes and continue to monitor it more closely.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS, visit https://bit.ly/KF-Disclosures.
