Are Advisors Rethinking Index Investing?

Indexes don’t play favorites, but clients might ask you to.

As sub-categories of various technology sectors (ahem … artificial intelligence) continue to dominate stock market performance, financial advisors are starting to question the pros and cons of passive broad market index investing. While the longer-term perspective has favored low-cost index funds over bull market periods, more recent market volatility and lopsided performance by select sectors has advisors taking a closer look at what’s inside ETFs, like market giants the Vanguard Total Stock Market Index Fund (VTI) and the State Street SPDR S&P 500 ETF Trust (SPY). While those funds have bargain basement expense ratios of 3 basis points and 9 basis points, respectively, low cost can come with tradeoffs when it means owning losers in the index right alongside winners.

“The setup that made indexing nearly unbeatable for 15 years was the internet era’s tailwind of cheap money, deep liquidity and a tide that lifted almost every boat, but AI may not be that kind of tide,” said Haley Schaffer, founder and managing partner at Waypoint West. “As AI reorders industries, the winners and the disrupted end up sitting in the same index, and cap-weighting makes you hold the losers all the way down,” she added. “That widening gap between the companies that adapt and the ones that get displaced is what brings selection back into play, and not just stock by stock, but also where you allocate, which sectors and which geographies.”

Everything, Everywhere, All at Once

Discussions of active management and individual stock selection go against the grain of what much of the financial planning industry has been riding on for decades, as the broader financial services industry cranked out cheap beta in the form of ETFs and mutual funds that seemed to package just about everything into a passive index.

“When dispersion runs this wide, the choices start to matter again instead of getting averaged away,” said Schaffer. 

Any index made up of hundreds of underlying companies will always have performance dispersion, but sometimes the extremes are too much to ignore:

• Inside the S&P 500, for example, you have a stock like Sandisk up more than 725% this year. 
• Micron Technology has climbed more than 280% as part of an index that has gained only about 9% over the same period. 
• But on the other end, there are laggards like Nike, down 35%, and Zoetis, down nearly 40%. 

“The past few months have seen a terribly skewed index, driven by just a few stocks,” said Chris Grisanti, chief market strategist at MAI Capital Management.

At this point, Grisanti is less focused on chasing individual stock performance than he is concerned about the leaders losing momentum. “Being a successful active stock picker is as much about what you choose not to own as what you do own,” he said. “Perhaps being devoid of the semiconductors that have doubled and tripled in price in the last few months can add a lot of alpha going forward.”

Passive Resistance

Eric Berlin, founder of Edgewood Wealth Management, described the concentrated performance within the major market indexes as one of the more “underappreciated risks” in the markets. “A small handful of stocks continue to drive a disproportionate share of equity returns,” he added. “We also see growing risk in index allocations to certain industry segments like semiconductors, which is a hyper-cyclical sector.”

Kimberly Abmeyer, wealth advisor at Ascentis Wealth Management, said even as an active manager, the current environment looks and feels unique. “While we have always been active participants in the equity markets, we believe the past one to two years have made it increasingly important to shift from a highly passive approach to a more active one for investors seeking outperformance,” she said. “Areas such as modern defense, artificial intelligence, space, robotics and energy are just a few examples of sectors benefiting from long-term tailwinds.”

Meanwhile, just like different perspectives make markets efficient, there are advisors who believe active management and stock picking is a fool’s errand. “Most individual stock opportunities are just additional risk, and as advisors, our job isn’t to find the next winning stock, it’s to help our clients reach their financial goals while taking the least amount of risk necessary,” said Chris Rawson, founder of Vision Based Planning. “If a client communicates that they want a riskier strategy, then fine, have a riskier diversified portfolio of ETFs and mutual funds,” he added. “If a client is driving the conversation and wants more risk in the portfolio, then there are strategic ways to do so with a diversified portfolio.”

The Index Strikes Back

The strong equity performance over the past decade has at least one advisor seeing a reason for less active management, not more. “For the past decade, many individual investors thought it was easy to beat the market by just buying growth and tech stocks where they saw instant returns,” said Alvin Carlos, financial advisor at District Capital Management. “But many of the popular names like Microsoft and Amazon have been underperforming, and US stocks in general have been underperforming international stocks for the past year.”

Carlos is sticking to his strategy of keeping the core portfolio passive with low-cost, broadly diversified index funds doing the heavy lifting. “The active strategies come from enhanced index funds that tilt the portfolio towards factors known to provide stronger long-term returns, like profitability, small size and better valuation numbers,” he said.

Game of Holdings. Grisanti of MAI Capital Management believes any shifts in strategy based on current market conditions come down to classic fear and greed perspectives. That’s because advisors fear deviating from the index, and clients simply don’t want to be on the losing end of a trade. “When markets are expensive and driven by exuberance, passive investing can become riskier than active investing, and I want to be able to choose what I don’t own in times like these.”

Schaffer of Waypoint West offers a similar perspective. “The case isn’t that passive is broken, it’s whether owning the index is still the best way to own innovation,” she said. “As innovation takes over the index, passive owns the disruptors and the disrupted together with no way to separate them, and the index quietly stops being diversification and becomes a concentrated bet you never actually chose.”

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