Portfolio managers have long understood the “big two” in long-term investing. These risks are systematic (market) and non-systematic (security specific). Market risk is the threat to a security that sends all stocks moving in the same direction. This occurs from economic expansions/contractions, changing interest rates, a change in the collective preferences of investors or a whole array of other factors (even a pandemic). Security specific risk is associated with a single investment. This is the risk that one company’s stock will perform poorly, independent of the overall stock market.  Declining sales, bad management, product obsolescence, malfeasance or anything that affects a company’s ability to deliver shareholder return can all contribute to security specific risk. Portfolio managers often eliminate most security specific risk by investing in multiple stocks (generally more than 30), from various sectors that are not perfectly correlated.

Portfolio managers view market risk as manageable (easy to model) and stock specific risk as easy to eliminate through diversification. Now, a third risk has emerged that all investors face. D’Arcy Capital labels this new risk as Index Risk. Index Risk is the threat to any individual stock or small group of stocks that exists purely because the stocks are highly concentrated within a single index or multiple indices. If the overall market is stable (low market risk) and the individual company is in great shape (low security specific risk), the stock may lose value simply because other investors are moving out of an index. When an index investor sells an index, the holdings within the index will be sold or redeemed without regard to the prospect of any individual stock. Because the most popular indices are often capital weighted (i.e., the stocks are held in the fund proportionally to their size), the largest companies (and the most concentrated holdings) within these indices will be sold in relatively higher quantities during redemption. 

Indices have always held plenty of unique risks (often ignored) that include recency bias, overweighting of overvalued stocks, large-company skewness, lack of risk management, and the lack of ability to make basic changes to allocations (no human oversight). However, this new Index Risk is not just the risk to investors who hold the index; it is a risk to investors who hold individual stocks that are highly allocated within an index. 

To some it may seem absurd that a fund manager would permit stock holdings to exceed 5% weighting within her or his fund. However, index funds and ETFs do not have the benefit of a portfolio manager to make these decisions. Concentrated holdings within index funds have developed as investors have increasingly invested in passive (index based) and exited active (management and research based) strategies. This created its own “tailwind” that elevated the market values of the largest holdings within each index, which in-turn increased the performance of index (passive) products, leading to more and more investment. While initially this momentum in index investing seemed harmless, now it is clear there is no concern for the individual weightings within these indices. Look no further than the Standard and Poor’s 500 Index of Stocks (S&P 500). In this index (and all the funds and ETF’s that replicate it), just six stocks (Apple, Microsoft, Amazon, Google, Tesla, and Facebook) account for over 25% of the entire index. In the Russell 1000 Growth Index (504 stocks) the weighting of these six stocks is 41%, and in the NASDAQ 100 Index (103 stocks) they represent almost 48%. This contradicts the very cornerstone (Modern Portfolio Theory) of long-term investing and risk/return principles.

For example: Microsoft, Inc. (sym: MSFT) is a highly rated company that generates over $160 billion in annual revenue, spread evenly across three different business segments. The company is a leader in its industry and has proven profitable for several decades. It should not face meaningful competition or a slowing demand for its services anytime soon. From an operational standpoint, it is hard to imagine investors would sell this stock based on a change in fundamentals. Investors who own individual shares of Microsoft cannot imagine a market environment where these shares underperform. However, the stock has a high Index Risk factor. Nearly 20% of the shares outstanding are held by four (Vanguard, BlackRock, State Street, and Bank of New York) firms.

In the Russell 1000 Growth Index, Microsoft accounts for 10.58% of the entire index. This is 53 times higher than the average holding (.19%) in the index. In a hypothetical $1,000,000 redemption from the Russell 1000 Growth iShares (sym: IWF), there would be a sell of $105,789 of Microsoft stock and just $1,961 of Chipotle Mexican Grill (an average weighted position in the index).

People who hold individual positions, do so, precisely to limit the effect other investors have on their financial situation. Most commonly, investors will choose to hold individual stocks (and not mutual fund shares) because they have greater control over capital gain and loss realization. Fund and index holders frequently are subjected to capital gains due to the redemption by other investors. The irony is that investors who own individual stocks (that are also a major holding within an index) may be highly impacted by the actions of fund and ETF participants. Just owning individual shares is not enough to insulate an investor from elevated fund redemptions due to Index Risk.

When there is a large sell-off in index products, the Index Risk will be manifested in underperformance for investors who own the largest index constituents. Currently, the connection between index investors and individual stockholders is overlooked. When determining exposure to any single stock (or group of six stocks) investors must look across all types of holdings (funds, ETFs, and individual stocks) to determine the stocks’ overall concentration. This vigilance must also extend throughout different investment strategies (personal, 401k, trusts, and IRA’s) to minimize Index Risk. If not already doing so, investors should consider allocating assets to actively managed strategies that still understand the responsibility of position, sizing, diversification, and risk management. Knowledge is the primary weapon in eliminating Index Risk.

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