Are Index Funds Headed for a Reckoning?

Passive investors may unwittingly be taking a huge active bet on the most overvalued sector of the market, according to new research.

Illustration by II

Illustration by II

Investors might think their index funds don’t actively bet on any companies or industry sectors. New research shows otherwise.

In the current market environment, investors are facing concentrated risks comparable to periods in the late 1990s during the historic run-up in the prices of technology stocks, according to a research paper expected to be released this week by index provider Syntax. Several core market-capitalization-weighted equity indices, which are considered to be diversified, are now exhibiting elevated levels of a new measure called active business risk, defined by the paper as the risk from an index being overexposed to a particular sector as opposed to being neutral on the market.

Investors who put money in index funds generally expect them to be neutrally positioned and well diversified, with the goal of capturing a broad market equity risk premium. That’s not happening right now, according to Syntax CEO Rory Riggs, research director Simon Whitten, and senior vice president Jonathan Chandler, who authored the paper.

“When [active business risk] is low, the index is broadly diversified,” Whitten explained in an interview. “From 2009 to 2018, the market wasn’t that vulnerable to shocks. We’re starting to get an orange/red signal that the market is taking more risk than usual at the industry level.”

According to Whitten, an increase in exposure to companies with similar vulnerabilities usually results in more volatility for the index. “Cap-weighted benchmarks are taking more of this business risk than usual,” he said. “And it’s probably more than people think they are taking.”

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For example, the active business risk of the Standard & Poor’s 500 index was 23.2 percent at the end of September 2019, according to the paper.

“This is above its long-term average due to the oversized exposures to certain technology-related business risks,” the paper stated. “Though the index is below the critical levels seen at the peak of the DotCom bubble, the Active Business Risk for the index is consistent with periods of poor performance.”

The authors noted that “smaller scale sector booms and busts occur frequently… and are usually coupled with weighting imbalances due to the simplistic way that market-cap-weighted indices operate. When viewed through a business risk lens, it is evident that investors may be taking significant positions in market segments that they do not realize or want.”

According to Syntax’s research, when the S&P 500, S&P 500 Value, and S&P 500 growth indices previously had active business risk above the 75th percentile, those indices had significantly lower performance in the periods that followed.

“In March 2000, the problem was a weighting problem,” Whitten said. “The sad thing is that people who bought a passive index fund wanted to capture the broad equity premium. They didn’t have a view, but they ended up being massively overweight in tech when it was at its most expensive. That’s playing out right now. We know this is the momentum effect and it will probably end badly.”