When Passive Turns Perilous: Unmasking the Potential Dangers of Index Funds
Mar 04, 2025Recently, one of our analysts inherited a grandfather clock. It is a beautiful piece that we are guessing is from the 1960’s. It was bought with the first commission earned by his mother-in-law who was a real estate agent in northern Wisconsin. When tuned properly, the clock’s pendulum is nearly hypnotic as it swings from one side to the other. The mood of the stock market has often been compared to the movement of a pendulum. However, unlike a grandfather clock, whose pendulum movement is predetermined and guided by gravity and gears, the stock and bond markets’ movements are said to be driven by less predictable emotions of fear and greed.
With 2022’s nearly 20% decline in the MSCI ACWI and 30%+ loss in the NASDAQ composite firmly in the rear-view mirror, we at MAP wonder whether 2023’s and 2024’s 20%+ consecutive gains are indicative of a market that has forgotten about the fear component. There is plenty of anecdotal evidence that seem to signal a market that has become overly bold. One of these pieces of evidence is how popular U.S. Exchange Traded Funds (ETFs) have become in the last two years. In 2023, ETFs grew by a (then) record of $800 billion; this record was short-lived as investors plowed more than one trillion dollars into U.S. based ETFs in 2024. The ETFs that attempted to replicate the performance of the S&P 500 and NASDAQ 100 indices were the biggest beneficiaries of these inflows.
The problem with the magnitude and direction of these inflows is that we believe investors are errantly extrapolating the returns of the last couple of years into the future. We furthermore believe that investors are failing to appreciate the risks associated with just how concentrated the investments that comprise these indices have become. When compared to last year’s 23% gain in the S&P 500, the index’s performance without the Magnificent Seven was a much tamer 6.3%. The outsized performances of the 5 leading stocks in the S&P 500 over the last two years has resulted in the largest concentration of these names in this index (which, by its name, is an index of 500 stocks) since the 1960’s when the stocks of the then monikered “Nifty Fifty” evidenced over-enthusiastic investors. To make matters more tense, this basket of highly concentrated stocks is trading at what we consider to be ‘expensive’ valuations, those that reflect sky-high expectations where even the smallest misstep could have hefty ramifications. As the chart below demonstrates, in 1964, AT&T, GM, Exxon, IBM, and Texaco comprised 27.60% of the S&P 500. Today, Apple, Nvidia, Microsoft, Amazon, and Alphabet make up nearly 29% of the index. As a further point of comparison, the ten largest stocks now constitute 33% of the S&P 500: more than double the 14% average since 1990.
We hear often of the ‘who cares’ argument. After all, the top stocks of the S&P 500 are wildly profitable and therefore deserve their outsized weightings. We cannot help noting that these arguments sound awfully similar to the arguments made during the times reflected in the table that follows.
Historically, the performance of stock markets have tended to revert to a mean. One stock or industry’s outperformance tends to be followed by underperformance. This makes intuitive sense. In a capitalistic society where competition drives business decisions, competitive edges are only held for so long. IBM’s stock price performance earned outsized returns in the 1980s as their mainframes were projected to be the future of computing – Apple and Microsoft saw things differently and IBM’s stock price suffered. Today, Nvidia captures a nearly 75% profit margin on their latest generation chips. Companies such as Advanced Micro Devices and Intel are all working to capture these outsized gains over time and could ultimately result in Nvidia’s underperformance.
More broadly speaking, from a commonsense perspective, the outperformance of the top seven technology stocks that drove the index’s performance for the last two years seemingly have to revert to a mean. Furthermore, the rise of the markets has created a vast amount of wealth. Year-to-date, the current administration’s economic agenda has created a sizeable amount of economic uncertainty in the broader markets. What investors expected would become a panacea has translated into increased volatility. If the economy were to roll over and the job market deteriorates, broader indexes will likely be negatively impacted. The next few years may just demonstrate the importance an active manager can have, as compared to passive index fund investing. From an active value manager’s perspective, as we seek to deliver the best risk-adjusted returns, we intend to find opportunities not only among these 493 forgotten names, but in the thousands of stocks throughout the world that have not drawn as much attention as these seven popular stocks.
We encourage you to contact your MAP representative with any questions or concerns.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, Zachary Fellows, John Dalton, and Nicolas Vilotti
March 4, 2025
Certain statements may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. The information contained herein represents our views as of the aforementioned date and does not represent a recommendation by us to buy or sell this security or any other financial instrument associated with it. Managed Asset Portfolios, our clients and our employees may buy, sell, or hold any or all of the securities mentioned. We are not obligated to provide an update if any of the figures or views presented change. Past performance is no guarantee of future results.
