Many investors rely on one or two index funds. They are simple, have low fees, and offer broad market exposure. Yet many index funds have structural limits that may leave critical needs unmet.
Why one index fund might not be enough
Index funds are designed to replicate the performance of a specific market benchmark, which provides you with instant diversification across a wide range rities. An index fund that tracks the Wilshire 5000 includes a broad spectrum of companies, reflecting the performance of the entire U.S. stock market. This extensive diversification can reduce the impact of any single company’s performance on your overall investment return.
However, not all index funds offer the same level of diversification. Major indices like the S&P 500 are currently heavily weighted towards a small number of large companies, particularly in the technology sector. This concentration can amplify sector-specific risks and increase portfolio volatility.
When a handful of firms dominate an index, its performance can become increasingly tied to those companies, which may not accurately represent the overall market.
Hidden risks
Many index funds are constructed using a market capitalization-weighting method, which means that the size of each company in the index directly influences how much of that stock is included in the fund. As a result, the larger companies, like Apple or Microsoft, represent a disproportionate share of the fund compared to smaller firms.
This weighting method leads to a significant tilt in exposure toward these dominant companies and, by extension, the sectors they belong to, like technology. While you may believe you are diversifying your holdings across a wide array of industries by investing in an index fund, your investment may be heavily influenced by the performance of a few large companies.
This concentration of risk becomes particularly problematic during periods when these leading companies experience downturns. If Apple or Microsoft’s stock prices decline, the impact can be felt across the entire index fund, leading to losses even if the majority of the sectors are performing well overall.
Increased volatility
A “bond buffer” refers to the stabilizing effect of bonds within an investment portfolio. Stocks are generally more volatile, while providing higher potential returns over the long term, which means their prices can fluctuate significantly in shorter time frames, leading to considerable ups and downs in the value of a portfolio that consists solely of equities.
When a portfolio is exclusively composed of growth-oriented equities, there is no built-in mechanism to cushion the impact of sudden market downturns.
Incorporating bonds into a portfolio serves multiple purposes. Bonds tend to be less volatile than stocks. They provide a steady stream of income through interest payments. This income can help offset losses or declines in the stock market, effectively smoothing out overall returns. It also provides liquidity during market downturns, allowing investors to remain invested in equities while drawing income from bonds.
Factor tilts can add an edge
Smart beta, also known as factor investing, is an investment strategy that combines characteristics of both passive and active management. Unlike traditional passive investing, which typically tracks a market index, smart beta employs specific rules to tilt the investment portfolio toward certain factors that have historically offered higher returns or lower risk.
These factors may include:
Value: This strategy focuses on underpriced stocks relative to their fundamentals.
Size: This approach targets smaller companies, which tend to outperform larger ones over the long term, although they tend to be more volatile.
Momentum: This strategy invests in stocks that have shown strong performance in the past, and the belief that they will continue to do well in the short term.
Quality: This factor emphasizes investing in companies with strong fundamentals, high profitability, low debt, and consistent earnings growth.
Low volatility: This strategy focuses on stocks with less price fluctuation, aiming to reduce risk while providing steady returns.
One of the main advantages of smart beta strategies is their transparency. You can easily understand how these strategies work, what factors are being targeted, and how the portfolios are constructed.
Smart beta approaches can potentially provide better risk-adjusted returns over the long term. This means that they aim to deliver a more favorable return in relation to the amount of risk taken. While there are no guarantees in investing, and smart beta can have periods of underperformance, for long-term investors, it offers a systematic way to harness market anomalies and potentially increase returns while keeping costs low.
Final thoughts
Index funds claim to provide diversified exposure, low cost, and simplicity. However, they may fall short on income generation, inflation protection, volatility management, and diversification. That is why more sophisticated portfolios add bonds, broader diversification, and factor-based strategies.
