Hidden Risks Of Index Funds: What Investors Should Know

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Index funds are sometimes touted as among the best methods to take a position for the long-term and for good cause. They will provide immediate diversification at low prices and largely outperform lively funds over the long term.

However as a smaller variety of corporations — referred to 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 actually passive.

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

How the Magnificent Seven entered the chat

The thought behind passive investing is that it’s pointless to attempt to do higher than the market averages over time, so the perfect 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 based mostly on market indexes such because the S&P 500.

Slightly than attempt to establish which shares will do properly or poorly, index funds make investments solely based mostly on the underlying index that they observe. So if an organization includes 3 % of the S&P 500, that’s how a lot an S&P 500 index fund will spend money on it as properly.

As a result of the S&P 500, and plenty of different inventory market indexes, are market-cap weighted, the biggest corporations make up the biggest 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

In recent times, seven shares have come to dominate the foremost market indexes attributable to their sturdy outperformance. Microsoft (MSFT), the biggest firm within the S&P 500, has a market cap that’s about thrice that of the sixth-largest firm, Broadcom (AVGO).

Because the shares of the biggest corporations within the S&P 500 have seen combined efficiency this 12 months, with some rebounding after declines early within the 12 months, 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.

Buyers in S&P 500 index funds is probably not getting what they’re on the lookout for in a fund, says Nick Ryder, chief funding officer at Philadelphia-area wealth supervisor Kathmere Capital Administration. These traders are usually on the lookout for broad diversification and contribution from many alternative shares, however as an alternative they’re inherently having a bet on these seven corporations, he says.

The affect on the Nasdaq 100 Index was so pronounced {that a} particular rebalancing of the index befell 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 befell.

Ryder says that enthusiasm round synthetic intelligence is partially chargeable for the outperformance of the biggest shares, whereas including that investing based mostly on narratives could be harmful for traders.

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

Index fund options

Buyers seeking to restrict their publicity to the Magnificent Seven shares, whereas nonetheless taking an index-based strategy, have a number of choices.

• Purchase an equal-weighted fund: The primary different 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 it will likely be dramatically decrease than a typical S&P 500 index fund.
• Purchase a value-based fund: One other selection can be to purchase value-based funds, equivalent to funds that make investments based mostly on metrics just like the price-to-earnings ratio. These funds spend money on shares that seem low-cost based mostly on quantitative metrics. The Magnificent Seven shares largely include premium valuations, so worth funds could maintain them in decreased weights or by no means.

In Kathmere shopper portfolios, Ryder says they’re making an attempt to mitigate the affect of the seven largest corporations by making considerate changes to the S&P 500, whereas acknowledging it’s troublesome 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 based mostly on fundamentals,” Ryder mentioned. “It’s not an either-or resolution, it’s about making an attempt to steadiness the dangers.”

Index fund FAQs

— Bankrate’s Logan Jacoby contributed to an replace.

Editorial Disclaimer: All traders are suggested to conduct their very own impartial analysis into funding methods earlier than investing resolution. As well as, traders are suggested that previous funding product efficiency isn’t any assure of future value appreciation.