Portfolio diversification has long been one of the most important tenets of successful investing. One of the easiest ways for investors to achieve diversification is to invest in funds that are designed to track diversified indices in various asset classes. Using equity-based index funds allows investors to avoid the need to research individual companies, instead allowing them to gain access to some of the most widely-held stocks in the world.
While investing in such funds is a sound practice, investors should still understand what they are getting when they buy into certain indices. For example, in the equity index space, many indices are very top heavy due to how the index is constructed. In particular, the NASDAQ 100 Index is a capitalization-weighted index. With this approach, if the largest companies in the index outperform the smaller ones, the index can quickly become relatively concentrated to a handful of names. In this case, the 5 largest companies in the index (Apple, Microsoft, Amazon, Facebook and Alphabet) represent almost 47% of the index due to the recent outperformance of their stocks, a level that puts extreme reliance on the performance of this handful of stocks.
Some investors also migrate to funds tracking the Dow Jones Industrial Average, an index that is price-weighted rather than cap-weighted. A critical consideration with this type of index is the impact on the index weighting with changes in a stock price, such as when a stock splits. For instance, Apple recently announced a 4:1 stock split which would result in the weighting of that stock going from about 11% in the Dow Jones Industrial Average to only about 3%.
We believe in the value of index investing for many investors, but also encourage investors to get to know the indices they invest in to make sure they are comfortable with the level of diversification they provide.
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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss.
