The stock market goes through periods where it seems like things aren’t making any sense. Often, driven by liquidity and investor greed, valuations get out of whack. These periods are usually characterized by a frenzy for certain types of stocks. In retrospect, we call them bubbles. 

Looking back through history, a characteristic of these periods is that the broad market indices become dominated by a few large names that drive performance and therefore attract investor funds, creating a virtuous cycle for those who got in early. We thought we saw this pattern reverse last year, but so far 2023 has marked a resumption in the trend which kicked into high gear in 2020 - market dominance by a few large technology stocks (formerly known as the FAANGs, I’m not sure what we are supposed to be calling them today). 

Performance has become increasingly concentrated in the top stocks. Apple and Microsoft alone make up over 13% of the S&P 500 index. With each of these stocks trading in the neighbourhood of 30x earnings, this isn’t a healthy situation and doesn’t bode well for future index returns.

As the chart above shows, this kind of concentration is often seen at market peaks. And so today, I present a timely excerpt from Low Risk Rules, where I comment on the flaws I see in “passive” investment strategies, particularly at times like today. (Note that the passage below was written in late 2021.)

Shitty indices

A big problem with indexing is—and please excuse my use of the technical finance term—shitty indices.

I’m Canadian, and this is a big issue up here. As I write this, if you decide to create a passive portfolio tracking the Toronto Exchange benchmark, you’ve made the decision to hold an abnormally high allocation to bank stocks, energy companies, and gold miners. Your health care allocation is basically just cannabis stocks. And your technology sector exposure is focused around two companies. Your largest position for most of the past year was Shopify, which is a great company but an expensive, momentum-driven stock whose volatility makes it difficult to own for many people. (At the time of writing, it has fallen almost 50 percent in just two months, which kinda proves my point.)

And lest you think I’m cherry-picking a particular data set, at various times in the past your “passive” allocation to Canadian equities saw your largest position being in stocks like Valeant Pharmaceuticals (which was subsequently censured for fraud and accounting tricks) and Nortel (a wildly overvalued telecommunications stock in the tech bubble that never actually generated any free cash flow). Both of these stocks subsequently declined by over 90 percent. Nortel was a zero.

Basically, what I’m trying to get at is that the Canadian equity benchmark is a shitty index, and you don’t want to have much of your wealth in it. If you are invested in it, you need to know that you’re highly levered to oil and commodity prices. In your effort not to choose investments (by implementing a passive strategy), this is the economic exposure that you have chosen.

I’m picking on Canada only because I know it so well, but any number of countries that rely heavily on a single industry or multinational company will have the same issue. Passively investing in their benchmarks is a bad idea, because the benchmarks themselves are shitty.

It is at these times, and in these markets, when buying indices is a horrible idea. When you aren’t buying a well-diversified basket of stocks at all, but one or a few highly correlated large companies or one large industry that dominates index movements. That’s a shitty index, full stop.

The other problem you may have picked out is that the largest companies and sectors in any given index will change over time. It usually happens around market tops, when “hot” industry groups and companies make up a dangerously large percentage of the index. As I’m writing this, the S&P 500 is dominated by Apple, Microsoft, Amazon, Meta, and Google, which together represent around 25 percent of the index. Now, these are all huge, powerful companies that generate strong cash flows. But they are also the drivers of market performance, and consequently have become central to a huge momentum trade. So someone buying the S&P 500 is making a bet on these companies’ shares continuing to defy gravity—and there’s no way around that. In trying to be “passive,” you have made the decision to believe that the prices of these five stocks will continue to rise unabated.

The S&P 500, which is the main benchmark used by US stock investors, from time to time can become a shitty index.

This isn’t unprecedented, and it seems to happen mostly around market tops, when investors are at their most ebullient. In 1973, the market was dominated by the “Nifty Fifty,” which, similar to today’s technology superstars, were being purchased by investors at any price. Avon at 61x earnings? Check. Polaroid at 94x? Yep. Disney at 71x? Load up the truck.

The subsequent 1973/74 market decline remains one of the worst drawdowns on record.

So when you buy an index, what exactly are you buying?

If you’re a Canadian who bought the TSX Composite any time in the past ten years, you’re rolling the dice between having a 10 percent or a 25 percent energy allocation. And counter to what you should be doing (buying low and selling high), you’ll buy more when the sector is expensive, and less when it’s cheap.

Buying high and selling low.

If you bought the S&P 500 in 2014, you had a 14 percent allocation to technology. If you bought the same index in 2020, just six years later, you had a 28 percent allocation to the same sector, and at much higher valuations. That’s a wild swing. Do you know what it means for your portfolio volatility and risk? Do you know if it’s appropriate for you?

And if the S&P 500, the mother of all indices, can become shitty, what hope is there for the rest of them? And if formerly good indices can become shitty slowly and imperceptibly over time, are you really comfortable relying on a passive approach to protect your wealth?

Too often, and usually at precisely the wrong time, indexing steers investors into more concentrated, momentum-driven trades, increasing risk.

Who is watching your “passive” investments for you?

A problem with passive investing is that, to do it well, you actually need to be more active than anyone lets on. It’s ultimately active management, implemented through baskets of stocks chosen for you by anonymous committees and automated criteria.

Is your advisor making sure to adjust your risk exposure as the makeup of these indices changes, and as their risk increases?

If so, you’re probably paying for it, which may negate the supposed cost advantages of the passive approach.

There is no such thing as truly passive investing. And that’s a good thing.