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Why Index Investing Isn’t Enough

  • January 28, 2021
  • Noah Weidner

Originally posted on Front’s Medium blog.

If you count yourself among the 55% of Americans who own stocks, odds are you own an index fund. In the last two decades, index funds have become the backbone of the investing economy. ETFs and mutual funds tracking the S&P 500, NASDAQ 100, and Russell 1000 have offered Main Street investors exposure to a short-list of America’s biggest and best companies.

The growth of cheap, passively-traded, buy-and-hold indexing strategies have turned killer results. Over the last 10 years, index funds have consistently returned double-digit annual gains. $SPY, a prominent index fund which tracks the S&P 500, has returned 13.76% annually on average. The tech-heavy $QQQ, which tracks the NASDAQ 100, has pulled down an even more impressive 20.36% annually. 

After hearing about the track record of index funds, you might be inclined to throw all your money into these funds and let it ride. History suggests that isn’t necessarily a bad strategy, but you’d be leaving chips on the table. Index funds are generally limited to several hundred companies, selected and hand-picked by committees with respect to factors like earnings and fundamentals. However, there’s more to investing than just indexes – especially for investors who are actively engaged with what’s going on in markets. Capitalizing on new trends and up-and-coming companies before they make it to the big leagues will require you to look beyond the index paradigm. Let’s take a look at a few reasons why index investing isn’t enough and what you can do to fill holes in your investment strategy.

Index funds miss many high-growth companies

Given the large amount of consolidation in the top players in indexes, index funds are increasingly positioned as ‘value-growth’ plays. The funds are predominantly filled with large-cap companies with track records of earnings success. However, a small number of those companies are actually still growing. 

Take Amazon, one of the biggest components of big indexes like the S&P 500, NASDAQ 100, and Russell 1000. Despite its massive $1.5 trillion market cap, Amazon’s YoY (year-over-year) growth is still well into the double-digits. In that sense, it is both a ‘value’ and ‘growth’ play. There are quite a few components in index funds that are like Amazon. However, the emphasis on ‘value’ ultimately means that investors could be missing out on big growth stories.

There are literally hundreds of financial publications which write articles about “what $10,000 invested in [some company] in 2000 would be worth today.” In truth, it’s very unlikely that the companies they’ll be writing about will be companies that everybody knows about. After all, green energy stocks are just now making inroads to index funds – some after running up 500%.  

In short, indexes often do not attempt to be prognosticators of what will make the biggest gains. They seek stability in what is already successful and look to deliver consistency to investors. In order to find alpha and meaningful opportunities for upside, you’ll have to do that research yourself.

Investing in index funds is a safe, traditional strategy

One thing can be said about index funds: they work. Otherwise, they wouldn’t be turning double-digit percentage growth for decades on end. However, they might be held back by old-fashioned beliefs about the market. In the last few years, retail traders have transformed the landscape of the stock market. Increasingly, fundamentals are taking a backseat to innovation and change. 

Perhaps, the retail traders have a point. Green energy companies like Tesla only joined the S&P 500 after reaching a $500 billion market cap. Meanwhile, the S&P 500 are still invested in oil and tobacco giants. Is that really where America wants to invest its money? This might explain the rise of ethical, socially responsible investing and ‘ESG funds’, which aim to only include companies with strong environmental, social, and governance (ESG) standards.

For any indication that core index funds are being dragged down by old-fashioned, potentially unethical businesses, we can take a look at one such ESG fund: $SUSA, which tracks large and mid-cap U.S. companies with “leading ESG practices.” $SUSA, like many adjacent ESG funds, turned higher returns than other indexed strategies.

Chart source: TradingView

Index investing puts lots of eggs in one basket

Over the last ten years, the top holdings of various index funds have started to look the same. In fact, the top components of the NASDAQ 100 and S&P 500 are almost identical. They include companies such as Apple, Microsoft, Amazon, Tesla, Facebook, and Alphabet. This is because many index funds are weighted by market capitalization, or the worth of a business.

This isn’t necessarily a bad thing, but the presence they command in the fund has arguably made it harder for other companies to pull meaningful weight in the funds. Maybe if you’re bullish on tech, you might not be too concerned. However, given changing attitudes about America’s biggest tech companies, this might be cause for concern. In a great irony, the index funds – which have been hailed for offering exposure to lots of different equities – are actually not as diverse as they’ve been sold to be. If any one of these six companies trip up, run into legal or political trouble, or face new competition, then it’s possible that the index funds will pay a hefty price.

Index funds limit exposure to broader market

There are thousands of companies on markets. Only a few hundred are represented in index funds. For example, the S&P 500 only has 500 large-cap companies in it. The NASDAQ 100 only has 100 companies. I’m sure you get the picture.

These companies are hand-picked by a selection committee that is considering any number of inclusion criteria. However, they are ultimately made to balance these factors for inclusion against another company’s exclusion. If a company is to join the NASDAQ 100, one must be removed. This remains the case with many market cap-based index funds.

For that reason, index funds might not offer as much exposure to the market as aggressive investors might want. In order to find that exposure, they often seek it out in active funds, passively-traded indexes of industries and sectors, thematic funds, or through their own research on individual stocks.

Ultimately, the research is one of the most daunting and challenging aspects of tapping into markets. With so many websites, forums, and influencers telling you what to buy and what not to buy, it’s easy to get lost in the noise. That’s why Front is passionate about giving individual investors the information and insights previously only available to professional investors, and making it easy to understand. 

Front’s smart FISCO technology quickly assesses the risk of each stock based on company financials, stock performance, recent news, and more, representing the stock’s risk rating with a single number. Index investing is a time-tested, traditional strategy, but if you’re looking to take matters more into your own hands to find promising, unique investment opportunities, Front makes your stock research easier than ever. It’s powerfully simple and it’s free. Get the Front app and start making smarter investment decisions. 

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