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The Deception of Index Funds

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Despite your investment style, taking a moment to understand what you own is worthwhile. 

If you own indexed mutual funds of ETFs, you may be less diversified than you realize.

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Investing In Index Funds

Sausalito, CA: Investing is both an art and science. We use scientific tools to measure the probability of return distributions, analyze financial statements for patterns in the data, and follow economic models. But like artists, success depends on thinking creatively about other’s psychology, differentiating your style, and taking risks that science cannot perfectly explain. These facets of investing lead to a wide range of philosophies and only a few agreed-upon methods throughout the industry. Political risk, natural disasters, and most recently viruses have proven many theories imperfect. However, some old adages from icons such as Benjamin Graham and Warren Buffet remain lasting on Wall Street. The one that is most striking today is the timeless saying, “don’t put all your eggs in one basket.”

Professional investors agree that diversification is one of the keys to success, although the degree of diversification is still highly debated – Graham proved that a portfolio of only 15 to 30 stocks was necessary to achieve maximum diversification benefits almost a century ago.[1] Curiously, active investors often compare, or benchmark, their returns to Standard & Poor’s 500 market capitalization weighted stocks (or the global basket for international investors). One might argue this is too diversified, but even more curiously, indexes are concentrated in just a few, large, powerful technology companies. It’s hard to understand why we would compare these two types of portfolios: one where each slice represents about 3% of the pie, while in the other pie, some slices represent 7% and other slices represent .01%. The contrast between these two styles is clear.

Market breadth is being studied and antitrust is being debated, but what does this all mean for individuals today? Diversification, our industry’s one universal risk management tool, has now become opaque. 16 percent of the MSCI World Index is comprised of Apple Inc (NASDAQ:AAPL), Alphabet Inc (NASDAQ:GOOGL) (Google), Meta Platforms Inc (NASDAQ:FB) (Facebook), Amazon.com, Inc. (NASDAQ:AMZN) and Tesla Inc (NASDAQ:TSLA). 24 percent of the S&P 500 is comprised of these names. The contribution of return that these companies have on the overall return of the index is astoundingly positive, but it can quickly change. Yes, many of them have large cash positions and have high quality earnings. Yes, this accurately represents the largest sector of the American economy and society has proved that very little will inhibit demand for these companies’ products and services. But will investors let this trend of concentration continue and be lulled into forgetting the one agreed upon rule of diversification? The contribution to return can also be very negative, so we sure hope not.

Psitive Biases

Many blame the proliferation of passive investing, the explosion of mutual funds, and the burgeoning ETF business for the current situation. Indeed, every two weeks when the bulk of Americans get a paycheck, a sizable percentage is passively invested in these very indexes – funneling the most funds into the largest holdings and reinforcing a cycle. Even professional investors haveo psitive biases towards these familiar, faithfully performing companies. The current concentration of technology companies is the most profound in history, but with the belief that the market is not perfectly efficient and a world obsessed with data, we believe that active investors can still deeply sway the market back on track.

The speed at which things historically change is especially reassuring. Just 13 years ago, some of the biggest companies in the S&P 500 were Exxon, Citigroup, AT&T and Walmart. These companies were all deeply affected by the prior decades themes: we have dethroned energy goliaths, restructured the financial system with Dodd-Frank and other post financial crisis regulation, deemed smart phones a way of life and a business necessity, and empowered small businesses online. So, when we look at today’s themes, we wonder whether the S&P’s kings and queens will continue to rule in 2035. What would an artist or entrepreneur do to address increasing consumer privacy concerns? Or a desire to work remotely forever? What about global warming or China’s looming threat? These are just the themes apparent today, but surely there are others, invisible to us now.

The current situation alongside the historical precedence of change makes us thankful to be active, individual stock investors. Indexed strategies may face significant pressures in years to come, especially given that we are at the most consolidated point in history. The illusions of diversification in today’s indexes are real, and investors would be wise to remember the idea we once all agreed on, “don’t put all your eggs in one basket.”

[1] Graham, Benjamin. The Intelligent Investor. 1949.

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About Main Street Research

Founded in 1993 and built on the principles of Trust & Reliability, Main Street Research has $1.8B under management and an international clientele. The firm has been consistently named as a Top Advisor by Financial Times and James Demmert has been recognized as a Barrons Top Advisor for a number of years in  a row. Founded in the San Francisco Bay Area 28 years ago, Main Street Research now has offices on both coasts, serving clients across the country. MSR’s culture has always been based on a team and goals-based approach. Every client relationship is approached as a team effort with the goal of exceptional client service and enhanced performance in both up and down markets. Therefore, the team’s compensation is based on salary and revenue growth. These metrics of compensation keep the culture focused on the most important factors: client retention and enhanced assets under management. MSR is an active risk manager, mitigating risk through adjusting asset allocation (in keeping with client investment policy), sector exposure, and the use of actively managed stop-loss orders on parts of a client’s portfolio. The firm believes that a disciplined risk management process is critical to excellent long-term performance, particularly in today’s uncertain world.

About Lily Taft

As a Portfolio Manager at Main Street Research, Lily adds depth to our team’s research process across both the investment management and trading teams. Lily serves on the Investment Policy Committee, analyzing client specific asset allocations, sector exposures and security selections. She is actively involved in managing, executing and implementing trading strategies. In addition, Lily reviews and monitors daily updates and news from the firm’s outside research partners. Lily also leads our firm’s ESG (Environmental, Sustainable, and Governance) and cryptocurrency research efforts. Lily is a graduate of Tulane University’s A. B. Freeman School of Business with a Bachelor of Science Management (BS) in Finance and Management. She co-authored several Burkenroad Reports during her tenure, which covered companies under-followed by Wall Street. While a student at Tulane, Lily also served as an active member of the Darwin Fenner Student Managed Fund, which was allocated capital to invest on behalf of Tulane’s $1.3 Billion Endowment. She recently passed the Chartered Financial Analyst (CFA) Level 1 Examination and is a candidate for the Level 2 Exam. She also holds a Series 65 securities license.