Passive investors may be better off not being overexposed to any one sector

The rise of passive investing using exchange-traded funds (ETFs) has been well-documented. For sure, there are massive benefit of these vehicles in terms of management of costs and, in some cases, enhancing returns. However, they need to be used carefully to help you achieve your long-term financial goals, especially given increasing concentration risks in recent years.

Let’s start with some basics. One potential definition of a passive investor is somebody who does not pay attention to what is happening in markets and just invests every month in a truly diversified portfolio. This is the optimal approach for most investors and is the most likely to help you achieve financial success.

Of course, it also has the upside of you being able to focus on other things in your life such as your family, career and hobbies.

Active vs. passive managers

The question is: Should such an investor invest via an active manager – for example, a mutual fund – or via a passive approach, such as an ETF?

A typical ETF attempts to give the investor the same return as a pre-determined index or a selection of stocks. It does not try to outperform. The benefit here is you don’t need a team of portfolio managers and analysts trying to pick which stocks or bonds will outperform, which reduces the cost of investing. These savings can be passed onto the investor.

An active manager, however, says we can do better than this. By doing bottom-up research, we can identify companies that have better fundamentals and can outperform over the longer term.

History shows that very few can achieve this, especially over the long run. Asset managers have a way to manage this. They close underperforming funds and launch new ones until they stick.

The laws of probability mean a manager will, at times, outperform and this will attract increased inflows as investors view the outperformance as skills-based, and therefore sustainable, rather than luck, only to be disappointed later.

So, the case for passive investing has been quite compelling.

Drawbacks of passive investing

However, the composition of ETFs and what it tracks matter. If an ETF is based on broad market indices, such as the US S&P 500 index, then there is a formal established process for determining which stocks are included in the index. This historically ensured the index was well diversified across sectors and companies.

For thematic ETFs, the process is much more subjective and qualitative. By their very nature, such ETFs are less diversified. This is unavoidable. For instance, in ETFs focussed on the Generative AI theme, the concentration of some of the market leaders is exceptionally high since there are few pure AI plays on the theme.

However, a high level of concentration is increasingly present even in major indices, upon which the largest ETFs are based. Let’s take one of the most important equity market benchmarks globally, the S&P500 index – a collection of just over 500 US large companies.

The top 10 stocks in the S&P500 index now account for over 33% of the weight of the index. The bottom 50% of stocks account for just 10%. Meanwhile, the skew to technology stocks has increased dramatically. The top 4 industry groups are internet, semiconductors, software and computers, which account for over 40% of the index.

Therefore, even a global benchmark for equities, the US S&P500 index, is becoming an increasingly focused play on the US technology sector.

Way forward

What should we do? This is a great question that is being posed by my two teenage boys who are starting out on their investment journey. The easiest route is to accept the increasing concentration risk because this reflects the current market pricing on the opportunities of the companies involved.

For most people - my sons included - it is still probably a good starting point. However, the biases in index-construction need to be understood and considered, especially given current valuations.

One way to tackle this challenge would be to identify other forms of diversification within equities, such as the US Russell 2000 index of small cap stocks, or the UK FTSE 100 or Eurostoxx 50 indices, representing non-US equities.

You could also consider an allocation to an equal-weighted index that ignores the size of the company. This can give a very different sector breakdown. For instance, real estate investment trusts, or REITs, are top of the industry pile for the US S&P500 equal-weighted index.

There is another route, of course. If you can find a fund manager with a long-term track record of outperformance and is benchmark agnostic - they pick stocks with little or no regard for what the benchmark is - then allocating a portion to this type of fund may make sense.

Of course, the percentage allocation to such a fund manager should depend on your confidence in the manager’s ability to maintain that outperformance. We know that the manager will have a good story on why the performance is skill-based, but we also must understand that nobody, including the managers themselves, knows whether the fund will be successful in the future.

Therefore, the optimal outcome is to allocate across different markets, different indices within markets and across both passive and active managers. We need to balance the concentration risks increasingly evident in some major equity index ETFs, but also the risk of over-estimating the ability of fund managers to outperform these ETFs.