Rethinking Index Investing

“I do think that index investing, if everyone did it won’t work. But for another considerable period, index investing is going to work better than active stock picking when you try and know a lot. ” – Charlie Munger

Exchange-traded funds (ETFs) have become a go-to investment for many retail investors, with financial advisors frequently recommending them as a reliable, long-term strategy. The prevailing wisdom is to buy a low-cost ETF and hold it for years—a view even Warren Buffett endorses. This advice is everywhere, from YouTube to financial blogs. I once owned VOO, Vanguard’s S&P 500 ETF, but currently, I don’t hold any ETFs in my brokerage accounts, though I may include an index fund in my retirement plan.

Recently, the Financial Times reported that, according to Morningstar and Bloomberg, there are now more ETFs than individual stocks. This explosion includes leveraged ETFs, which are widely regarded as risky and unsuitable for most investors. Terry Smith has highlighted the dangers of these products, especially the complexities of shorting them. There are also ETFs that invest in illiquid assets, introducing hidden risks that can catch investors off guard.

Another concern is the growing concentration within major indices. The “Magnificent Seven” tech stocks now account for over 30% of the S&P 500. This means that, despite holding hundreds of stocks, index investors are heavily exposed to just a handful of companies. Such concentration undermines the idea of true diversification and can lead to what’s been dubbed “diworsification.”

If retail investors were to sell off ETFs en masse, it could spark a market event reminiscent of Black Monday in 1987. The top five S&P 500 ETFs now manage over $2 trillion, while the S&P 500’s total market cap exceeds $50 trillion-a ratio that keeps climbing. A sudden wave of ETF selling could strain market liquidity, raising questions about whether the system could handle such pressure.

Index ETFs are also forced to buy and sell based on index changes, not investment merit. When Tesla joined the S&P 500, for example, all related ETFs had to buy Tesla shares—sometimes at inflated prices—while selling other holdings to rebalance. This mechanical buying and selling can amplify market swings, as ETFs must purchase more of the stocks that are already rising in prominence, fueling momentum rather than providing true diversification.

I recently watched a Howard Markets video on index investing. One of his main points was that index ETFs are built on the belief that active investing is ineffective. Passive investing aims to deliver the market’s average return, minus fees. But it’s crucial to remember that ETF prices are ultimately set by active market participants—hedge funds, institutions, and sometimes large groups of retail traders.

So, is it still wise to “index”?

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Rethinking Index Investing

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