Hidden Risks Of Index Funds: What Investors Should Know

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Index funds are sometimes touted as the most effective methods to take a position for the long-term and for good purpose. They will provide prompt diversification at low prices and largely outperform energetic funds over the long term.

However as a smaller variety of corporations — known as the Magnificent Seven — have come to dominate the inventory market and the indexes that observe it, some are questioning whether or not passively managed index funds are really passive.

Right here’s what you could find out about index funds and the hidden dangers your portfolio could also be uncovered to.

How the Magnificent Seven entered the chat

The concept behind passive investing is that it’s pointless to attempt to do higher than the market averages over time, so the most effective plan of action is to maintain your prices low and broadly diversify your holdings. The invention of index funds made it straightforward to take a position primarily based on market indexes such because the S&P 500.

Moderately than attempt to determine which shares will do nicely or poorly, index funds make investments solely primarily based on the underlying index that they observe. So if an organization contains 3 % of the S&P 500, that’s how a lot an S&P 500 index fund will put money into it as nicely.

As a result of the S&P 500, and plenty of different inventory market indexes, are market-cap weighted, the most important corporations make up the most important weights within the index and within the funds that observe them. That’s how the Magnificent Seven enters the chat, creating challenges as these seven massive corporations have vastly outperformed the broader market and grown to account for a big portion of index fund portfolios.

The hidden participant in index funds

Lately, seven shares have come to dominate the main market indexes resulting from their robust outperformance. Microsoft (MSFT), the most important firm within the S&P 500, has a market cap that’s about 3 times that of the sixth-largest firm, Broadcom (AVGO).

Because the shares of the most important corporations within the S&P 500 have seen blended efficiency this yr, with some rebounding after declines early within the yr, the Magnificent Seven proceed to account for much more of the index. These seven shares make up about 34 % of the S&P 500 as of June 2025, up from 20 % in 2023.

Traders in S&P 500 index funds might not be getting what they’re searching for in a fund, says Nick Ryder, chief funding officer at Philadelphia-area wealth supervisor Kathmere Capital Administration. These buyers are sometimes searching for broad diversification and contribution from many alternative shares, however as an alternative they’re inherently betting on these seven corporations, he says.

The impression on the Nasdaq 100 Index was so pronounced {that a} particular rebalancing of the index came about in July 2023 to keep away from violating diversification guidelines for the funds that observe the index. The seven tech giants accounted for greater than 60 % of the index earlier than the rebalancing came about.

Ryder says that enthusiasm round synthetic intelligence is partially chargeable for the outperformance of the most important shares, whereas including that investing primarily based on narratives may be harmful for buyers.

“The issue with narratives is that they are typically totally mirrored in inventory costs,” Ryder says.

Index fund options

Traders seeking to restrict their publicity to the Magnificent Seven shares, whereas nonetheless taking an index-based method, have just a few choices.

• Purchase an equal-weighted fund: The primary various can be to purchase an equal-weighted S&P 500 index fund. Because the title implies, an equal-weighted fund holds shares in equal weights, no matter their underlying market caps. So a $1 trillion firm is held in the identical proportion as a $50 billion firm. You’ll nonetheless have publicity to the seven largest corporations, however will probably be dramatically decrease than a regular S&P 500 index fund.
• Purchase a value-based fund: One other alternative can be to purchase value-based funds, resembling funds that make investments primarily based on metrics just like the price-to-earnings ratio. These funds put money into shares that seem low-cost primarily based on quantitative metrics. The Magnificent Seven shares largely include premium valuations, so worth funds might maintain them in diminished weights or in no way.

In Kathmere consumer portfolios, Ryder says they’re making an attempt to mitigate the impression of the seven largest corporations by making considerate changes to the S&P 500, whereas acknowledging it’s tough to outperform a market-cap weighted index over the long-term.

“We’re simply taking the general S&P 500 and tilting towards issues which can be low-cost on fundamentals, and away from issues which can be costly primarily based on fundamentals,” Ryder stated. “It’s not an either-or choice, it’s about making an attempt to stability the dangers.”

Index fund FAQs

— Bankrate’s Logan Jacoby contributed to an replace.

Editorial Disclaimer: All buyers are suggested to conduct their very own impartial analysis into funding methods earlier than investing choice. As well as, buyers are suggested that previous funding product efficiency is not any assure of future worth appreciation.