For a long time, investors have sought refuge in index funds, or baskets of stocks meticulously crafted to spread risk across a broad array of companies. This strategy provides diversification and accomplishes the golden rule for investors: Do not put all your eggs in one basket. 

Many, if not most, financial advisers meticulously follow this strategy. It provides a simple, low-cost path to efficiently manage client portfolios in a relatively straight forward and low risk professional manner. 

However, in the past few years there has been a flaw developing with some eggs in the basket becoming appreciably larger than all others. This has led to basket imbalance with some of the eggs starting to fall out and getting cracked. Potential doom lies on the horizon unless portfolio managers, investment consultants and financial advisers take corrective action fast.

At the end of the day, better baskets with more balanced security holding compositions may soon become mandatory. This year is already showing indications of where we are headed. Pretty soon, it might be too late, and some financial advisers could be held liable for recommending an index with extreme concentration risk.

The original concept of “indexing” was a strategy hailed for its simplicity and effectiveness. Trillions of dollars flooded into passive index funds, driven by the allure of low-cost, low-effort investing. Amidst the success of indexing, though, a troubling trend emerged. The weight of the top holdings began to swell, reaching alarming levels of concentration within the indices. Suddenly, what was once hailed as a prudent investment strategy became a precarious gamble—a gamble that many institutional investors (e.g. pension funds, insurance companies, endowments, portfolio consultants) have unwittingly joined.

The rise of passive investing, while initially celebrated for its accessibility and cost-effectiveness, has inadvertently created a ticking time bomb of market concentration. Acronyms have emerged to describe the top conglomerate of stocks dominating the indices. The popular “FAANGS” has been replaced with the “Magnificent Seven,” led by behemoths Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet and Tesla.

For the past two years these seven stocks have driven most of the index performance. To be clear, there are more than 15,000 exchange traded funds and mutual funds that invest across 66,000-plus publicly traded companies around the world. However, the vast majority of assets are concentrated in a mere handful of U.S. large capitalization companies.  

Moreover, as additional funds pour into the market, buoyed by the promise of mirroring benchmark returns, the demand for the underlying holdings skyrockets. This relentless buying spree propels the prices of the top weights to dizzying heights that rise irrespective of traditional (fundamental) underlying valuation metrics. This creates a massive disparity in performance returns that belie most popular indices.

The Russell 1000 Growth Index is a case in point. This index represents the 1,000 largest U.S. publicly traded securities and a variety of ETFs that are designed to mirror this performance. Hundreds of billions, traded by both retail and institutional investors, follow this index. Notably, more than 52 percent of the total weight are concentrated in just the Magnificent Seven. And while 2023, was celebrated as a terrific year for most of the constituents, the Magnificent Seven could quickly become fatal when/if valuations begin to crumble.

Take for example the YTD performance of the Russell 1000 Growth ETF (as of March 31, 2024). Thus far, four-fifths of the total 10 percent Index return can be attributed to just four Magnificent Seven stocks: Nvidia (4.2 percent), Meta (1.4 percent), Microsoft (1.3 percent) and Amazon (.9 percent)! And the performance would have been appreciably higher if two of the percent holdings—Apple and Tesla—did not plummet this year. These two have reduced the total index return by 2.2 percent—one-fifth of the total index return!

In summary, just six stocks, out of an index of 1000 constituents, dominate all the remaining holdings (Note: the other percent holding, Google, has been flat YTD). In other words, removing all members of the percent significantly reduces the volatility of both positive and negative returns surrounding the remaining index constituents. 

Opportunistic traders may have already started to capitalize on index concentration and lofty valuations. Apple and Tesla, which both have massive weights in the index, are down 11 percent and 30 percent YTD respectively (as of March 31, 2024). This could be a foreshadow of things to come. 

But it is not only the U.S. large cap indices that are heavily concentrated—the U.S. small cap indices are even more distorted. Take for example the popular U.S. small cap growth index, IWO. YTD almost 80 percent of the returns came not from U.S. small cap stocks, but from U.S. large capitalization and U.S. mid capitalization stocks. 

In precise terms, only 22 percent of the weight came from U.S. small capitalization stocks, and those produce a contribution of -1 percent, whereas the mid cap and large cap stocks produced a positive contribution YTD of almost 9 percent. Moreover, even though the U.S. Small Cap Russell 2000 Growth Index is supposed to be representative of 2,000 components, 75 percent of the return came from only 10 stocks, which were purely large and mid-cap stocks.

In this case, the investor benefitted from the index misrepresentation. But it’s important to note that this data only represents three months and implies that the opposite scenario can—and will—occur when true U.S. small caps start to outperform U.S. large and mid-caps. The key takeaway is that the U.S. Small Cap Growth Index (IWO) does not truly represent U.S. small caps and financial advisers have a potential liability if they are selecting indices without understanding the underlying components. 

For institutional investors and portfolio managers tasked with safeguarding their client’s interests, the dilemma could not be starker. 

Should the fiduciary duty extend to passively adhere to a benchmark index even at the risk of jeopardizing their clients’ portfolios? Is it even theoretically possible to alter a benchmark index in a manner quick enough to avoid disaster?

While fiduciaries measure their options in real time, they may be exposing their clients to significant risk with a highly concentrated portfolio with large weights in declining stocks or if they select an index that does not truly represent the legal investment parameters. Notably, while few clients have economic incentive to take legal action against fiduciaries while the Magnificent Seven (for the U.S. large cap index) or large/mid cap holdings in the IWO are on a spectacular upward trajectory, the corollary is far from certain on a vicious downward descent. 

In future years, fiduciaries may look back at the early signs in 2024 and regret not having taken prudent action sooner.  

As the debate rages on, a glimmer of hope may yet emerge. A new paradigm of investment strategy may become standardized that truly embraces portfolio diversification without sacrificing market exposure or benchmark risk. 

By constructing a larger basket of stocks highly correlated with the benchmark, investors could mitigate sector-specific risks while still capturing market returns. Moreover, should the Magnificent Seven continue to erode, a basket of securities that underweight or eliminate the Magnificent Seven would likely generate risk-adjusted returns relative to the underlying benchmark.  

But this alternative approach does not occur without its challenges. Achieving both high correlation to a benchmark, sans the core holdings, is no easy feat and remains elusive for all but a select few.

The winds of change may begin to stir and the era of blind allegiance to a passive index without regard to concentration risk and unacceptable portfolio volatility may be ending. The replacement vehicle may return to a more traditional benchmark measure that better balances risk and reward. The path forward will ultimately not lie in blind conformity to a herd mentality, but in the wisdom to chart a new course balanced with opportunity and prudence.