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Index Fund Pitfalls: What Investors Need To Know

In his 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel contended that higher cost, actively managed mutual funds were flawed and unlikely to beat low-cost, passively managed index funds. Following the publication of Malkiel’s book, there were dozens of studies touting similar benefits associated with low-cost, passively managed index funds. Today, index funds are rising in popularity, and many investors blindly rely on them without truly understanding what differentiates one index fund from another.

Despite the fact that index funds have increased significantly in popularity, little attention has been paid to the pitfalls of the most popular funds. Many index funds are capitalization-weighted, meaning they proportionately allocate more money to larger companies. For example, if one stock in the index is twice as large as another stock, twice as much money gets allocated to the larger stock. This can create a disproportionate amount going to the largest companies. Furthermore, if a certain sector of the stock market is performing well, this can create an abnormally large amount of money being allocated to that sector, which can increase risk. One of the most popular capitalization-weighted index fund strategies affected by this issue is the S&P 500 index.

Before taking a closer look at this problem, it is important to understand a few basics regarding the sectors that comprise the S&P 500. Historically, the S&P 500 has been comprised of the following sectors: consumer discretionary, consumer staples, energy, financials, industrials, healthcare, materials, technology, telecommunications, and utilities.

The sectors that make up the S&P Index grow or shrink based on the relative size and number of stocks in each respective sector. In the 1990s and early 2000s, technology stocks performed well relative to stocks in other sectors. The strong performance from these stocks increased the size of these stocks, which ultimately increased the size of the technology sector within the S&P Index.

Near the sector’s peak in 1999, technology stocks accounted for 29.2% of the S&P index. Unfortunately, people who invested in certain index funds that followed the S&P Index thought they were diversified, but due to the capitalization weighting, they ended up owning a large amount of technology stocks and smaller amounts of other sectors. The following graphs illustrate the weights of the S&P Index along with the subsequent post-1999 10-year performance of these sectors, based on information from Seeking Alpha and Dimensional Fund Advisors, respectively.


As you can see from the second graph, over the next decade, technology stocks were the worst-performing sector, declining 51.52%. In addition, some of the top-performing sectors (energy, consumer staples, utilities, and materials) consistently had lower weightings compared to the technology sector during this time frame.

Following the tech stock crash, a new bubble was quietly brewing in the financial sector. This sector had strong relative performance and grew to be the largest sector in the S&P Index. At its peak in 2006, the financial sector represented 22.3% of the S&P Index. Over the next 10 years, the financial sector lost 3.53%. Some of the smaller sectors in 2006 ended up growing by over 100% during the same 10 years, including but not limited to industrials, consumer discretionary, consumer staples, and healthcare.

Since the two most recent market crashes mentioned above, a few things have changed. A new classification system for the S&P Index now includes the following 11 sectors: communication services, consumer discretionary, consumer staples, energy, financials, healthcare, industrials, information technology, materials, real estate, and utilities. The information technology sector of today is similar to the technology sector of the past. However, some of the stocks that previously would have been included in the information technology sector, such as Facebook and Alphabet, are now included in other sectors. In 2018, according to Reuters, Facebook and Alphabet were moved from the information technology sector to the telecommunications services sector, which was subsequently expanded and renamed the communication services sector.

Despite this change, the information technology sector is the largest sector of the S&P 500. The large size of this sector can partially be attributed to the strong relative performance in information technology stocks, which had a 50.3% return during 2019. Unfortunately, the sectors that perform well for extended periods also tend to be the sectors that get hit the hardest in market downturns. In other words, the bigger they are, the harder they fall.

What Can You Do?

Not all index funds follow capitalization-weighted indexes. To determine if you have excessive amounts in the sectors mentioned above, you can use Yahoo Finance’s website to research your mutual funds and determine your sector weightings.

If you are in danger of having too many eggs in one basket, there are several low-cost index fund options that use allocation methods other than the capitalization weighting method. Another, potentially even lower-cost approach could include building your own portfolio of stocks that spans multiple sectors and gives you complete sector control. As with any investment strategy, it is important to consider these alternative approaches in relation to many factors, including your risk tolerance, time horizon and other various financial variables.

Originally published in Forbes February 13, 2020

Learn why you may be able to retire earlier than you think.

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Learn why you may be able to retire earlier than you think.
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