The deception of index funds

Despite your investment style, taking a moment to understand what you own is worth it.

If you own ETF index mutual funds, you may be less diversified than you think.

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Invest in index funds

Sausalito, California: Investing is both an art and a science. We use scientific tools to measure the probability of return distributions, analyze financial statements for data trends, and track economic models. But like artists, success depends on thinking creatively about the psychology of others, differentiating your style, and taking risks that science can’t fully explain. These facets of investing lead to a wide range of philosophies and only a few agreed-upon methods across the industry. Political risk, natural disasters and, more recently, viruses have proven many theories flawed. However, some old adage from icons like Benjamin Graham and Warren Buffet lives on on Wall Street. The most striking today is the timeless saying “don’t put all your eggs in one basket”.

Professional investors agree that diversification is one of the keys to success, although the degree of diversification is still much debated – Graham proved that a portfolio of just 15-30 stocks was needed to get maximum diversification benefits nearly a century ago.[1] Curiously, active investors often benchmark, or compare, their returns to Standard & Poor’s 500 market-cap-weighted stocks (or the Global Basket for international investors). You could say it’s too much diversified, but even more curiously, the indices are concentrated in a few large and powerful technology companies. It’s hard to understand why one would compare these two types of portfolios: one where each slice is about 3% of the pie, while in the other some slices are 7% and other slices are 0.01%. The contrast between these two styles is clear.

The scope of the market is studied and antitrust is debated, but what does all this mean for individuals today? Diversification, the only universal risk management tool in our industry, has now become opaque. 16% of the MSCI World Index is made up of Apple Inc (NASDAQ: AAPL), Alphabet Inc (NASDAQ: GOOGL) (Google), Meta Platforms Inc (NASDAQ: FB) (Facebook), Amazon.com, Inc. ( NASDAQ: AMZN) and Tesla Inc (NASDAQ: TSLA). 24% of the S&P 500 is made up of these names. The contribution of the performance of these companies to the overall return of the index is surprisingly positive, but it can change quickly. Yes, many of them have ample liquidity and high quality income. Yes, this accurately represents the largest sector of the US economy and the company has proven that very little will inhibit demand for these companies’ products and services. But will investors let this concentration trend continue and be lulled into forgetting the agreed-upon diversification rule? The return contribution can also be very negative, so we hope not.

Passive biases

Many blame the proliferation of passive investing, the explosion of mutual funds, and booming ETF business for the current situation. Indeed, every two weeks, when the bulk of Americans receive a paycheck, a significant percentage is passively invested in these same indices – funneling the most funds to the biggest holdings and reinforcing a cycle. Even professional investors have pessimistic biases towards these familiar and successful companies. The current concentration of technology companies is the deepest in history, but with the belief that the market is not perfectly efficient and a world obsessed with data, we believe that active investors can still profoundly put the market back on track. rails.

The speed at which things are changing historically is particularly reassuring. Just 13 years ago, some of the biggest companies in the S&P 500 were Exxon, Citigroup, AT&T and Walmart. These companies have all been deeply affected by the themes of previous decades: we have dethroned the energy giants, restructured the financial system with Dodd-Frank and other post-financial crisis regulations, viewed smartphones as a mode of life and business necessity, and empowered small businesses online. . So when we look at today’s themes, we wonder if the kings and queens of the S&P will continue to reign in 2035. What would an artist or entrepreneur do to address growing consumer privacy concerns? Or a desire to work remotely forever? What about global warming or the impending threat from China? These are only the themes apparent today, but there are surely others, invisible to us now.

The current situation as well as the historic priority for change makes us grateful to be active, individual investors in equities. Index strategies could face significant pressure in the years to come, especially as we are at the most consolidated point in history. The illusions of diversification in today’s indices are real, and investors would do well to remember the idea we all agreed on, “don’t put all your eggs in one basket”.


[1] Graham, Benjamin. The smart investor. 1949.

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About Main Street Search

Founded in 1993 and founded on the principles of trust and reliability, Main Street Research has $1.8 billion under management and a global client base. The firm has been consistently named a Top Advisor by the Financial Times and James Demmert has been recognized as a Barrons Top Advisor for several consecutive years. Founded in the San Francisco Bay Area 28 years ago, Main Street Research now has offices on both coasts, serving clients across the country. MSR’s culture has always been based on a team and goal-oriented approach. Every customer relationship is approached as a team effort with the goal of delivering exceptional customer service and improving performance in both bull and bear markets. Therefore, team compensation is based on salary and revenue growth. These compensation metrics keep the culture focused on the most important factors: client retention and improving assets under management. MSR is an active risk manager, mitigating risk by adjusting asset allocation (in accordance with the client’s investment policy), sector exposure and the use of actively managed stop-loss orders on parties of a client’s portfolio. The company believes that a disciplined risk management process is essential to excellent long-term performance, especially in today’s uncertain world.

About Lily Taft

As a portfolio manager at Main Street Research, Lily adds depth to our team’s research process across both the investment management and trading teams. Lily sits on the Investment Policy Committee, analyzing client-specific asset allocations, sector exposures and security selections. She is actively involved in the management, execution and implementation of trading strategies. Additionally, Lily reviews and monitors daily updates and news from the company’s external research partners. Lily also leads our company’s ESG (environment, sustainability and governance) and cryptocurrency research efforts. Lily graduated from the AB Freeman School of Business at Tulane University with a Bachelor of Science in Management (BS) in Finance and Management. She co-authored several Burkenroad reports during her tenure, which covered companies under-tracked by Wall Street. While a student at Tulane, Lily was also an active member of the Darwin Fenner student-run fund, which received capital to invest on behalf of Tulane’s $1.3 billion endowment. She recently passed the Chartered Financial Analyst (CFA) Level 1 exam and is a candidate for the Level 2 exam. She also holds a Series 65 credential license.

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