For the first time ever, investing in US passive funds has become the primary wealth-building tool for millions of investors over actively managed funds.
As of 31 August, US passive equity funds overtook active funds by around $25bn to make up 50.15% of the market, holding $4.27tn in assets, according to data from Morningstar. The average expense ratio of passive funds fell to 0.15% in 2018, compared to 0.67% for active funds.
However, there has been some debate that index funds, a form of passive investment, are heading for a bubble. Famed investor Michael Burry – who made a fortune shorting toxic securities prior to the financial crisis – has raised concerns that similar patterns to those seen prior to the crash have emerged. You can read more on this, here.
So with this in mind, determining whether now is the time to invest in an index fund is crucial.
What are index funds?
Generally, an index fund consists of a hypothetical portfolio of securities that represent a particular market or a segment of it. Some of the most well-known indices that are constructed to match or track the performance of a financial market index are the S&P 500 and FTSE 100. Both are made up of the companies with the highest market values listed on their respective stock exchanges, giving investors broad market exposure, low operating expenses and low portfolio turnover.
In 1976 John Bogle, founder of Vanguard Group, launched the first index fund, the Vanguard 500. Since then they’ve come a long way, especially given that reports have suggested that the majority of active funds have underperformed the market over the past 10 years.
As of November 2018, there were more than 3.7 million indices globally, according to the Index Industry Association, and the Investment Company Institute estimates that these hold close to $10tn.
This rise has been fuelled by the fact that they are generally advised as an ideal portfolio holding for retirement for their inexpensiveness and the fact that they also benefit from not being tied to the success of one entity.
Legendary investor Warren Buffet told CNBC in 2017 that “the trick is not to pick the right company,” but rather “to essentially buy all the big companies through the S&P 500 and to do it consistently.”
However, passive strategies, particularly ETFs, do have the potential to amplify volatility. During the last two major bear markets – the dotcom crash and global financial crisis – passive funds experienced significant cash inflows on both occasions, an Irish Times report based on Vanguard figures found.
Why index funds are heavily weighted with tech stocks
Trading tech-related stocks has become a regular occurrence for most investors due to them being highly liquid and easily tradable and some of the most well-known tech stocks are firm regulars in indices. In July last 2018, CNBC figures showed Amazon [AMZN], Netflix [NFLX] and Microsoft [MSFT] accounted for 71% of the S&P 500’s H1 returns in 2018.
As of the end of September, the tech-heavy Nasdaq Composite had a one-year return rate of 25% and two-year return rate of 70%, outperforming the S&P 500’s 15% and 34% respectively.
But not all analysts are confident that high-growth tech stocks are as sure bets as they once were. David Kostin, chief US equity strategist at Goldman Sachs suggests that regulatory risk, the political landscape and rising market concentration could affect company fundamentals.
“The valuation premium for growth is elevated today relative to history; Software in particular now carries the highest multiples since the tech bubble,” he said in a note to clients on 27 September.
Picking stocks for a custom-built index
While there are many different index funds to choose from, when the markets are immersed in such uncertainty there’s also the ability to create a custom-built index to diversify out of wider market fluctuations.
Custom-built index funds can use very different investment strategies to traditional funds while the advantages include a more significant exposure to assets from different regions as well as the ability to trade on margin using one currency.
Here Opto features 10 stocks that make-up one of CMC Market’s custom indices the FANG+:
Between July last year and the start of 2019, antitrust regulations brought Facebook [FB] to its knees as its share price slumped more than 40%. Since then stocks recovered somewhat but still show considerable volatility – share price dropped 14% from a year high of $204.87 in July to $175.81 on 1 October.
The ecommerce giant Amazon has seen meteoric growth in the last five years, climbing 438% through 1 October to $1735, and Wells Fargo thinks it could still go higher. The bank has a price target of $2300 for the stock based on several growth vectors including its cloud and advertising businesses.
Apple [APPL] shares are selling high. Over the last five years the stock has risen 121%, giving it a hefty valuation of more than $1tn. However, since hitting a high of $232.07 on 3 October 2018, it has fallen 4.8% in the year following, as its flagship product – the iPhone – slows in sales.
While Netflix gained 330% in the past five years since to 1 October, it has fallen 30% since a peak in July of $381 as growing market competition and a loss of subscribers affected market sentiment. With shares trading as high as $386 and as low as $231 in the last year, the stock is proving volatile.
The dominance of Alphabet [GOOGL] in the search engine market has given it access to a mountain of data, which has given it a significant advantage in digital advertising, cloud computing and AI initiatives. The stock has gained 108% in five years to 1 October and with a 23.4% profit margin (TTM), analysts have remained optimistic about its growth.
Commonly referred to as the Amazon of China, Alibaba [BABA] has grown to dominate the Asian market, however, unlike its US counterpart it is free cash flow generative due to operating more as a middleman in the ecommerce industry. The company has also expanded into cloud computing and digital advertising, lifting its stock 91% over five years (to 1 October).
As China’s most popular search engine, Baidu [BIDU] has a large market hold with similar expansion plans to Google, given that it’s venturing into other areas such as AI. However, since last year the stock has been locked in a freefall due to macro events that have seen its share price down to 55% over five years.
The computer chipmaking market has seen astronomical growth in recent years with Forbes stating its now worth a staggering $469bn, while companies like Nvidia [NVDA] are at the forefront of its success. The stock’s five-year performance reflects this growth with an incredible 891% rise (to 1 October) but volatility in 2019 has analysts wary.
Known for an eccentric CEO who has a tendency to fluctuate Tesla’s [TSLA] share price with a Tweet, the electric car maker’s stock has been on a rollercoaster ride over the last five years, ending more or less where it began. The stock is down 1.8% in the five years to 1 October, despite gaining as much as 50% during peaks in 2017 and 2018.
Although Twitter [TWTR] share price dropped more than 20% in the last five-years, it has been growing steadily since 2017 with a 145% rise in the last two-years. Equally, daily active users – a key metric for the social media company – grew 14% year on year in Q2, suggesting the stock still has a way to go.