One of the easiest ways to invest in the stock market is to buy a good index-tracking mutual fund or exchange-traded fund (ETF). Trillions of dollars track the S&P 500 (SNPINDEX:^GSPC) through funds like the SPDR S&P 500 ETF (NYSEMKT:SPY), and you’ll find similar trackers for the most valuable stocks in the Nasdaq Composite (NASDAQINDEX:^IXIC) as well as all 30 members of the Dow Jones Industrial Average (DJINDICES: ^DJI).
Index funds are great ways to get cheap exposure to the entire market. But investors shouldn’t see them as perfect diversifiers because the makeup of the indexes themselves creates concentration risk that many people don’t even realize.
How the market fared on Wednesday
Stocks were generally mixed, with the Nasdaq moving to another record high. Other major benchmarks moved slightly lower but retained substantial gains for 2021 and over the past year.
The trillion-dollar club
Earlier this week, tech giant Microsoft (NASDAQ:MSFT) made news by becoming the second stock to sport a $2 trillion market capitalization. A slight decline on Wednesday took the software company slightly below that level, but it remained the second-most valuable stock in the U.S. market behind Apple (NASDAQ: AAPL).
Index funds are efficient ways to invest, but they’re only as good as the methodology behind the indexes they track. In the case of the S&P 500 and many other popular indexes, market capitalization defines how much weight a given stock will have in the index. Proponents of S&P index funds point to the fact that they typically include all 500 stocks that make up the index.
The problem with S&P index funds is that the weighting system gives huge influence to just a handful of stocks. The four stocks in the trillion-dollar market-cap club — Apple, Microsoft, Amazon.com (NASDAQ:AMZN), and Alphabet (NASDAQ:GOOGL) (NASDAQ: GOOG) — make up nearly 20% of the S&P 500. Just by buying an index fund, investors are heavily concentrating their investment in these four companies. By contrast, the bottom 250 stocks in the S&P 500 add up to far less than 20%.
Concentration effects are even worse in some other popular ETFs. Consider:
- All four of those top market-cap stocks also happen to be within the Nasdaq-100 Index, which the popular Invesco QQQ Trust (NASDAQ:QQQ) tracks. There, the four stocks add up to 37% of the total value of the index. That’s more than the 80 smallest stocks in the index combined.
- The Dow Jones Industrials are price-weighted rather than market cap-weighted, but the index also has plenty of concentration. Four stocks account for more than a quarter of the Dow’s value, and the top nine have roughly equal weight with the bottom 21.
Index investors are betting on mega-caps
None of this means that index funds are fundamentally flawed. But it’s important to realize that the diversification that you’re getting from an index mutual fund or ETF might not be as extensive as you think. Moreover, investing in a market cap-weighted index inherently means favoring larger companies over smaller ones. That might be consistent with the way you want to invest, but you might prefer a different method.
Once you realize that index funds have their own stock-picking biases, you might consider choosing individual stocks on your own. Contrary to popular belief, you could even find yourself with a safer and better-diversified portfolio than what you’d get from many index-tracking investments.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.