The Hidden Risks of Passive Investing

Passive investing has become a key part of the investing landscape for many investors, particularly for those looking for US exposure. Passive vehicles have been a great solution for many but it’s important to remember that not all passive funds have performed as well as the S&P 500 ETF, and this is why it’s critical to be fully aware of what stocks the ETF holds and what their weightings are.

The S&P 500, as we all know, is very weighted towards mega cap growth stocks, and this is why the ETF has done so well in recent years. But its weighting profile is so concentrated at the top of the market that incredibly 485 of the 500 stocks in the index have a weighting of less than 1%. That means that if you are buying an index tracker today you are banking on just 15 companies to deliver your returns, as the rest of the companies in the tracker have too low a weight to have a discernible impact on returns. And those 15 companies are already household names, with market caps already in the trillions, that have already been great performers. The original idea of index trackers was to get exposure to the broader market but given the lopsided make-up of the S&P 500 these days, this is no longer the case.

So, what of the broader market indices, are these a better bet in terms of diversified exposure? The Russell 2000 is probably the best known of the truly ‘broad market’ indices, and yet this index suffers from being too broad. One of its biggest sectors is Financials, which has been one of the worst sectors performance wise for some years. Although there has been some better performance since the October lows, Banks have not been a good place to be invested. The Regional Banks are now being hit by concerns over their Commercial Real Estate loan books. New York Community Bank has fallen by 55% since 30 January when it reported a big earnings miss driven by its increased provisioning for loan losses in its office portfolio. On the same day Aozora Bank, a Japanese Bank with large exposure to US Commercial Real Estate (CRE), announced it too would be taking big write downs and that in many US cities, its loan to value (LTV) ratios were well north of 100%. These concerns around CRE have been percolating for 18 months to two years now and companies are finally having to admit the real condition of their loan books.

We do not know which bank will be next to report a problem or when, most regional banks have already reported their Q1 numbers, but this is another cloud for this sector to deal with. And this is the big positive for active managers, we can see a problem and we can avoid a whole sector that is under stress. Passive investors don’t have this flexibility and if you are buying a Russell 2000 tracker today, you’re investing directly into this very risky sector.

As we move on from 2023, when mega cap growth held all before it, and we look at what is happening in 2024 we can already see a very different picture. Mega cap growth stocks are still performing fine in most cases, but there is new leadership coming from other stocks and this is where the VT Tyndall North American Fund is focused. As the market broadens out, active funds can really come into their own as managers can do what free market capitalism demands, which is to allocate capital to the best opportunities in the market and avoid those areas which are too risky or impaired. Passive investing does the opposite and that is why it’s so timely for investors to consider truly active funds alongside their passive exposures.