Investors put money into index funds when looking for a well-diversified and neutrally positioned investment vehicle. However, with more people choosing index funds, there are concerns that they can become overvalued. Is that really the case?
Index funds can’t be overvalued. However, funds weighted by market capitalization may slowly push investors towards overexposure in a few stocks, making some of them overvalued. In such a scenario, any negative impact on these stocks can affect the fund’s overall value.
The rest of the article will look at the value of index funds and the risks posed by the weighting approach. You’ll also see other reasons why some investors are slowly moving away from these investment vehicles.
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Index Funds and the Weighting Problem
Index funds on their own aren’t overvalued because their inherent value is dependent on the companies that make up the fund. However, these companies can be overvalued.
For example, in 2021, a low-profit company like Elon Musk’s Tesla was valued at more than 1,000 times its reported earnings. Throw in the volatile decision-making of the billionaire owner, and it’s easy to see why many analysts believe it’s overvalued.
Still, due to the market cap weighting used for an index fund like the S&P 500, you’d be risking 1–2% of your capital on Tesla alone if you choose to invest on any fund tracking the index. In such a fund, you’re putting more money on Tesla than in other more established brands with realistic valuations like General Mills, Wynn Resorts, Delta Air Lines, American Airlines, and more.
The weighting problem means that a quarter of your portfolio is invested in just 6 companies. These include Apple, Microsoft, Amazon, Alphabet, Facebook, and Tesla. For an index that supposedly holds 500 companies, that’s a lot of value placed on a few companies. Of course, many of them aren’t as overvalued as Tesla, but it’s a lot of bet on one sector.
So, in that regard, index funds may not offer the security and diversification that has made them so popular.
The Index Fund Bubble and What It Means
From blog articles to podcasts, there’s a lot of noise on how we’re in an index fund bubble. Does this mean that index funds are overvalued? Not really. The bulk of the analysis highlights the faux diversification problem we’ve covered above.
A report by Syntax Indices (link in article sources below) warns that index funds like the S&P 500 are heavily tilted towards tech stocks at a level not seen since the early 2000s. Other analysts are worried about what would happen to the stock market as index fund investors get older and start to withdraw money from the fund in retirement.
There’s the fear that such withdrawals and the volatility of tech stocks could have a significant negative impact on the market overall.
However, it’s not just the S&P 500 that’s got analysts and investors worried. Other index companies are also offering products heavily tilted towards a few companies.
For example, the Vanguard Total Stock Market Index Fund (VTSMX) is presumably more diversified than the S&P 500 since it has over 3,500 stocks. However, the 6 biggest stocks on the index account for more than 19% of the portfolio.
So, as long as most index funds are concentrated on stocks from a specific sector or a handful of companies, the core engine will always remain faulty. If they’re regarded as overvalued, it’s due to this inadequate diversification.
Other Reasons To Be Wary of Index Funds
The lack of true diversification isn’t the only reason more analysts and investors are wary of index funds. Other reasons include the following:
No Protection in a Bearish Market
The stock market will always print new highs over time, but between those highs are periods of significant drawdown. By investing in an index fund, your investments will remain exposed to the downside if the market goes into a drawdown. With single stocks, it’s easier to sell the most volatile stocks in a bearish market and buy them back later.
Some index fund investors try to counter the bearish market risk by buying an inverse fund or buying a put option on the index. However, fund managers may not offer such products for other less popular index funds outside the S&P 500.
Little to No Flexibility
Index investing makes reacting to market changes impossible in many cases. For example, in our discussion above, we mentioned that indexes can get overvalued, but stocks within them can. Outside an index, any experienced investor will want to lower their exposure to the overvalued stock, transferring more money to undervalued options.
You can’t achieve such flexibility with an index. Even when you can see a stock that’s undervalued or overvalued, you can’t take the necessary action to profit off that knowledge.
No Input Over Stocks in the Index
When you buy an index fund, you won’t have any control over the individual stock holdings in the portfolio. Going back to our Tesla example, if you feel like Elon Musk is too volatile or that the business model isn’t sustainable, you can’t ask the fund manager to exclude TSLA from the index fund.
Similarly, if you’ve researched and identified a few interesting businesses you’d like to buy shares in, you can’t include them in the index. You also can’t remove stocks of companies you believe have become unethical in the way they handle their business or take care of their staff.
The index is fixed, and any stocks to be listed or delisted must meet (or fail to meet) certain criteria. Investors have no say over which company should get on the index and which one shouldn’t. You’ll have to create a separate portfolio if you want that level of control.
Inability To Explore Different Strategies
Investors use a wide range of strategies to increase their chances of success in the market. When you buy an index fund, you can’t use those strategies. With the right strategies and learning how to combine value and growth stocks, some investors can get more returns than any index can offer.
They also don’t need 500+ stocks to achieve the results. In many cases, a portfolio of 30–40 stocks is enough.
A Lack of Satisfaction
If you’re an experienced investor, there’s a feeling of accomplishment that comes with managing a portfolio successfully. Going with an index takes away that feeling. The moderate returns from an index may be unsatisfactory depending on your goals and expectations.
How many investors will be happy with returns lower than 10% after a year of constantly following the markets?
Should You Discard Index Funds Completely?
You should look beyond index funds if you want flexibility and above-average returns each year. However, achieving such returns regularly is difficult even for the most celebrated fund managers. For many people, a passive index fund often delivers the most value over the long term.
If you’re unsure about what approach to go with, speak to your financial advisor for guidance.
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Conclusion
As a standalone, an index fund can’t be overvalued. However, the stocks that make up the index can become overvalued with time. Market-capitalization-based index funds may also end up tilting heavily towards a few overvalued stocks, making the index fund a less robust and diversified investment tool.
The risk of overexposure toward overvalued stocks and the other bottlenecks posed by index funds explains why more analysts are asking people to look beyond these products. However, a historically stable index fund like one tracking the S&P 500 will always yield better results for the average investor.
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