While 20 years ago, a passive approach provided well diversified exposure, the same is clearly not true today.
In the last 20 years, passive investing has become increasingly popular. Investors should be aware that the composition of these benchmarks have changed dramatically over this time. As a result, many of these benchmarks are no longer the ‘simple diversified access to markets’ that they may have been a decade ago. These benchmarks are now vulnerable to very specific risks inherent in today’s shifting economic and political tides.
The S&P 500 and tech
The S&P has had a phenomenal run, delivering an average annual return of 14% for the last 10 years. But that performance has been heavily concentrated in a handful of names. 38% of the return over that period has come from the technology sector, driven by excitement about new technologies such as AI.
How might this influence the future returns of the S&P 500? If the big tech names meet the earnings expectations that are embedded in current prices, and other stocks in the benchmark begin to do more of the heavy-lifting, then the S&P 500 could still produce strong future returns. Investors, however, should be mindful that the benchmark is highly dependent on the tech sector meeting elevated expectations (as discussed in our 2025 Investment Outlook). Though we are generally optimistic that over the medium term AI and other technologies will be transformative, history demonstrates that picking the eventual winners and losers requires significant knowledge and research in a rapidly moving space.
ACWI isn’t very global these days
Tech excitement has been a theme largely evident in the US and so the S&P has far outperformed other regional benchmarks. The share of the US market in MSCI ACWI Index has therefore grown substantially. An ACWI investor now has a larger part of their portfolio in Tesla – which is currently trading on a multiple of 132x forward earnings – than in the Korean stock market.
Global Agg skewed by misbehaving debtors
While the strongest performing companies see their weight in equity indexes grow over time, fixed income benchmarks determine index weights based on outstanding debt levels. Passive fixed income investors therefore make the largest allocations to the most indebted governments or companies.
While this has always been a challenge with bond benchmarks, regional concentration is a more recent issue. Massive issuance of US Treasuries to fund ever higher levels of US government spending has seen US sovereign debt make up an ever larger proportion of the global aggregate benchmark.
Passive portfolio perils
It’s worth thinking about how these shifts affect the risk exposures of a portfolio. Suppose an investor at the start of 2008 opted for a portfolio consisting of 60% stocks and chose the ACWI benchmark, and 40% bonds using global aggregate. The motivation for such a portfolio may have been to achieve a simple diversified portfolio that they could forget about.
If, however, they haven’t touched this portfolio, it has changed dramatically given the shifts in the benchmarks already discussed. For a start, it is now 79% stocks and 21% bonds so is considerably more vulnerable to a risk-off event. Similarly, the overall portfolio’s exposure to the US has risen from 41% to 57%.
Investors should consider the associated exposures; the performance of this portfolio is highly vulnerable to any broad-based disappointment in US tech, and any volatility that could arise in the US Treasury market if President Trump’s policies reignite inflation concerns. Indeed, it is possible that these two vulnerabilities are triggered concurrently if rising yields trigger a sell-off in tech stocks given their longer duration.
Investors should be aware of these risks of passive investing. While 20 years ago, a passive approach provided well diversified exposure, the same is clearly not true today.