It’s indisputable that constructing a well-diversified portfolio is the cornerstone of a sound investment strategy. And many investors believe they are doing just that when they buy mutual funds and ETF’s that track major indexes such as the S&P 500. But these investments might not offer buyers the diversification their names suggest, and in fact they may expose the buyers’ portfolios to unforeseen risks.
Here’s why. Managers used to compile unique portfolios of stocks—perhaps a few dozen, maybe even several hundred. But within the past decade, the advent and popularity of index investments such as ETFs and index mutual funds have allowed investors to purchase or liquidate an entire basket of stocks in a single trade. Now large amounts of money have begun to pour in and out of the exact same investments.
One-third of all the money flowing into US Equity ETFs in 2014 went to just three funds: the SPDR S&P 500, the iShares Core S&P 500 and the Vanguard S&P 500. Even more startling, at the end of 2014 these three funds alone held a whopping $314 billion — 27% of all assets in US equity ETFs. In the index world, the S&P 500 index is the 800-pound gorilla—an enormous concentration of capital. With the click of a mouse, a huge amount of wealth moves in and out of the very portfolio that has become increasingly recognized as the benchmark of overall market performance.
Here’s the problem. You may not think you’re buying a concentrated portfolio when you buy an S&P 500 fund because you assume that you’re buying an equal piece of 500 different companies. But the S&P 500 is a capitalization-weighted index. This means that the relatively small number of companies with the largest “market caps” (that is, the total value of all their outstanding shares) disproportionately dominate the index. At the end of 2014, 50 cents of every dollar invested into a share of the S&P 500 ETF was invested in just sixty stocks. And 17.5 cents of that dollar was spent to hold a mere ten of those sixty.
With everyone effectively buying and selling the exact same portfolio, activity is overconcentrated in just a few dozen securities. Many investors trying to buy or sell based on their changing perceptions of risk are unaware that they are merely chasing momentum and in effect buying the winners in ever-greater quantities. That’s a very successful strategy–but only as long as people keep following it. History has shown it to be ineffective long-term, since herds often change direction with the slightest of provocations. To avoid getting stampeded when everyone changes course, spend the time and effort on doing some research to make sure your portfolio is as diversified as you intended.
Kenneth A. Kamen is a managing director of The Mercadien Group and president of Mercadien Asset Management and Mercadien Securities, as well as the author of the highly acclaimed book from Bloomberg Press,”Reclaim Your Nest Egg: Take Control of your Financial Future.”
Follow him on Twitter @KennethKamen