We explore whether index funds are really as safe and diversified as investors might think. From the hidden concentration risks within the S&P 500 to the decisions behind supposedly passive investments, we unpack what investors need to understand before putting their money into index funds.
Are Index Funds Really as Safe as Investors Think?
Index funds have become an increasingly popular way to invest, offering a relatively simple, low-cost approach to building wealth without having to pick individual shares.
But as we discuss in our latest episode, there’s a common misconception that investing in an index fund automatically means your money is well diversified and your investment strategy is relatively low risk.
The reality is a little more complicated.
An index is essentially a collection of investments designed to represent a particular section of the market. For example, the S&P 500 tracks a selection of large US companies, while the NZX 50 represents a portion of New Zealand’s share market.
An index fund is the investment product designed to track the performance of that index as closely as possible.
The distinction matters because, while an index fund might hold hundreds of companies, your money isn’t necessarily distributed equally between them.
Many popular indexes, including the S&P 500, are weighted according to company size. This means larger companies make up a greater proportion of the index and consequently have a much bigger influence on its performance.
As Michael explains, investors can believe they’re spreading their money across hundreds of businesses when, in reality, a significant portion of their investment may be concentrated in just a handful of companies.
This creates an important question: how diversified is your investment portfolio?
Why Index Funds Aren't as Passive as You Think
One of the biggest selling points of index funds is that they’re passive investments.
Unlike actively managed funds, where investment managers make decisions about which companies to buy and sell, index funds are designed to follow a predetermined index.
However, as Michael explains, there’s a surprising amount of human decision-making involved before an index fund even exists.
The companies responsible for creating indexes establish rules determining which businesses qualify for inclusion, how they’re weighted and when they should be removed.
For example, inclusion in the S&P 500 isn’t simply determined by being one of America’s largest companies.
Businesses must also meet criteria relating to factors such as profitability, liquidity and company size.
These rules are regularly reviewed through a process known as rebalancing, where companies can enter or leave the index and their weightings may change.
The S&P 500 typically rebalances quarterly, although special rebalances can also occur.
This means investors aren’t simply buying an automatically generated representation of the market. They’re investing in a product that follows an index shaped by decisions made by a committee.
Michael raises another interesting distinction: the people designing an index aren’t necessarily trying to create the best investment portfolio for individual investors.
Their objective is to measure a particular segment of the market.
While those two objectives can overlap, they aren’t necessarily the same.
The Tesla Example: How Index Investors Can Miss Significant Growth
One of the most interesting examples discussed in the episode is Tesla’s inclusion in the S&P 500.
Despite experiencing substantial growth, Tesla didn’t initially qualify for inclusion in the index because it hadn’t met all the required criteria.
As Michael explains, by the time Tesla was eventually included, it had already become one of the largest companies in the United States.
In other words, investors holding an S&P 500 index fund didn’t receive exposure to Tesla through that index during much of its earlier growth.
This highlights an often-overlooked limitation of passive investing.
An index fund doesn’t necessarily capture a company’s growth from its earliest stages. Instead, it captures the performance of businesses once they meet the index’s inclusion requirements.
James and Michael also discuss how decisions around index inclusion can become more complicated when large companies enter public markets.
The broader point isn’t that index investing is fundamentally flawed. It’s that investors should understand the rules governing the investments they own and recognise that those rules can influence their returns.
The S&P 500's Hidden Concentration Risk
Perhaps the biggest concern raised in the episode is the concentration of investment exposure within the S&P 500.
Although the index includes approximately 500 companies, Michael explains that around one-third of its value is concentrated in just seven businesses, commonly referred to as the Magnificent Seven.
That’s a significant amount of exposure to a relatively small group of companies.
For someone who has invested their entire portfolio in an S&P 500 fund, it means a substantial portion of their wealth depends on the performance of those businesses.
James also highlights the concentration of these companies within the US technology sector.
Over recent years, investors with significant exposure to US technology companies have benefited from strong share market performance.
However, this success creates another challenge.
As markets continue to rise, investors can become increasingly comfortable taking risks without fully appreciating how their portfolios might perform during a downturn.
James describes the difficult position this creates for investment managers.
Having significant exposure to these companies introduces concentration risk if their share prices fall. But avoiding them altogether can also result in underperforming the wider market while those companies continue to deliver strong returns.
It’s a reminder that strong historical performance doesn’t necessarily mean an investment is appropriately diversified.
Does Investing in Multiple Index Funds Make You Diversified?
A common approach among DIY investors is to spread their money across several different index funds.
While this can improve diversification, Michael explains that simply owning multiple funds doesn’t necessarily mean you’re spreading your risk effectively.
Different indexes can hold many of the same companies.
For example, an investor might hold several funds that each have significant exposure to large US technology businesses.
Although their portfolio contains multiple investment products, they may unknowingly be investing in the same companies repeatedly.
This is why James encourages investors to look beyond the number of funds they own and examine the underlying investments.
Some important considerations include the geographical distribution of investments, the industries represented, the number of individual securities and the proportion allocated to different asset classes.
James uses Kernel’s High Growth Fund as an example, explaining that it holds approximately 400 individual securities.
He contrasts this with the portfolios Lighthouse Financial constructs for clients, which hold approximately 9,500 securities across different investments.
This isn’t to suggest that a fund holding fewer companies is necessarily a poor investment.
Rather, James explains that Lighthouse’s approach is based on combining different investment solutions, recognising that no single fund manager or investment product is necessarily the best at everything.
The goal is to ensure diversification is intentional rather than simply assumed.
Why Your Risk Profile Matters More Than Recent Returns
Another important consideration is whether your investment strategy aligns with your personal circumstances.
James and Michael explain that many investors are comfortable holding share-heavy index funds because markets have performed strongly over recent years.
However, when they have a more detailed conversation about investment risk, some investors discover they’re taking on more volatility than they would actually be comfortable experiencing.
This becomes particularly important for people approaching retirement.
James gives the example of someone aged 55 or 60 who has invested their entire retirement savings in the S&P 500.
If the share market experiences a significant downturn just as that person begins withdrawing money, they may be forced to sell investments at depressed prices to fund their living expenses.
This can permanently lock in investment losses and reduce the amount of money available to support their retirement.
For younger investors with a long investment time frame, holding a higher proportion of growth assets may be more appropriate.
However, as retirement approaches, factors such as the purpose of the money, withdrawal requirements, investment time frame and tolerance for risk become increasingly important.
The same investment strategy won’t necessarily suit someone in their twenties and someone preparing to retire within five years.
As Michael points out, market downturns aren’t simply a hypothetical possibility. They’re something investors need to be prepared for.
How to Build a More Diversified Investment Portfolio
While index funds come with their own risks, they can still be an effective way to build long-term wealth.
In fact, keeping investment fees low remains a central part of Lighthouse Financial’s investment philosophy.
The concern isn’t necessarily with index funds themselves, but with investors relying on a single product without understanding what they actually own.
A more considered investment strategy starts by looking at your overall financial position and identifying how your investments fit together.
This includes understanding how much exposure you have to different countries, industries and companies, as well as whether your portfolio includes an appropriate mix of growth and defensive assets.
James explains that Lighthouse’s investment portfolios focus on low-cost solutions, with additional exposure to smaller and more profitable companies based on their long-term investment philosophy.
Rather than concentrating everything in one fund, the approach involves combining different investments to create broader diversification.
Importantly, investors should also consider why a particular fund has performed well.
If a KiwiSaver or investment fund has delivered exceptional returns because of its exposure to US technology companies, it’s worth understanding whether that level of concentration is appropriate for your financial goals.
The strongest-performing investment over the past five years isn’t automatically the best investment for the next five.
Ultimately, successful investing isn’t simply about choosing a popular index or chasing the highest recent returns.
It’s about understanding the risks you’re taking and ensuring those risks are appropriate for the future you’re working towards.
Key Takeaways
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Index funds aren’t automatically low risk. While they offer a low-cost way to invest across multiple companies, the level of risk depends on the underlying investments.
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Passive investing still involves decisions. Index providers establish rules determining which companies are included, how they’re weighted and when changes occur.
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The S&P 500 is more concentrated than many investors realise. Around one-third of the index was held in the Magnificent Seven companies at the time of the discussion.
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Owning multiple index funds doesn’t guarantee diversification. Different funds may hold the same companies, creating overlapping exposure.
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Recent performance doesn’t tell the whole story. Strong returns from US technology companies can disguise concentration risk within an investment portfolio.
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Your investment strategy should reflect your risk profile. Age, investment time frame, financial goals and withdrawal requirements all influence the level of risk that’s appropriate.
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Low fees and diversification can work together. A well-structured investment portfolio can incorporate index funds while spreading exposure across different assets, markets and investment strategies.
Next Steps
Our Lighthouse Financial wealth advisers can help you review your KiwiSaver and investment portfolio, understand your exposure to risk and build a diversified investment strategy aligned with your long-term financial goals.
If you’d like to watch more, check out this episode below.
For a no obligation discussion to see how we can help you on the path to wealth, please contact us.
Disclaimer:
The information in this article is general information only, is provided free of charge and does not constitute professional advice. We try to keep the information up to date. However, to the fullest extent permitted by law, we disclaim all warranties, express or implied, in relation to this article – including (without limitation) warranties as to accuracy, completeness and fitness for any particular purpose. Please seek independent advice before acting on any information in this article.
