Index trackers provide cheap exposure to all the shares in a given index — the FTSE All-Share index, the AIM 100 index, the FTSE 100, the FTSE 250, or overseas indices such as Japan’s Nikkei 225 or America’s S&P 500.
They’re rightly popular with certain types of investor — novices, say, or those who don’t want to spend much time managing their portfolio, or those who want exposure to particular industries or countries.
But that doesn’t mean that they’re a smart move for everyone. Most index trackers aren’t suitable for income investors, for instance. Indices include both income stocks and growth stocks, and income investors usually find the dividends on offer from growth stocks to be too meagre for their taste.
And recent days have highlighted index trackers’ shortcomings for investors keen to avoid unwelcome turbulence in their portfolio valuations — those approaching retirement, say, or looking to liquidate part of their portfolio to fund a major purchase.
Bumps in the road
Global markets have had a bumpy start to August.
Japan’s Nikkei fell 12%, before clawing some of that back in a roller coaster few days. Elsewhere, the falls have been less extreme — or at least, less extreme as I write these words.
But with European, Far Eastern and North American all showing falls in the 3–5% range, it’s clear that traders are rattled.
By what, exactly? Two things seem to have conspired to bring about this nervousness.
Rattled traders
First, some American economic statistics — chiefly unemployment numbers — have been interpreted by traders as indicating that America may be perilously close to tipping into recession.
Personally, having looked at the numbers, and considered the alternative explanations, I think those recessionary fears are overdone.
But markets, remember, are driven by sentiment rather than facts. When traders are rattled, they’ll want to liquidate their positions, rather than risk being dragged down by markets falls. Better safe than sorry, goes their argument.
Second, there’s been a technology stock sell-off: some technology stocks are down by around 30% — particularly semiconductor stocks. The UK’s ARM Holdings, now listed on NASDAQ, rather than London, is down by a third in a month, for instance.
And in recent days, the contagion has spread to more mainstream technology stocks.
Pin, bubble, prick — and burst
Essentially, what’s happened is that some of the shine has come off artificial intelligence (AI). Semiconductor manufacturers — who make the specialist chips that power AI — were first to be affected, as the hype bubble started to deflate.
In America, Nvidia, for instance, was hit much like ARM, its shares having lost 30% of their value since the beginning of July.
Then it was the turn of the companies attempting to use those specialist AI chips to actually use AI to provide AI-driven services and products — Microsoft, Facebook-owner Meta, Google-owner Alphabet, and so on. All in, the companies in this AI ecosystem are often called the Magnificent Seven — Microsoft, Amazon, Apple, Alphabet, Meta, Nvidia and Tesla.
Their share prices are all down, as investors absorb the message that AI services and products are going to take longer to deliver then hoped, and be more expensive to develop.
Concentration risk
Which is rather hammering index trackers tracking America’s broadly-based S&P 500 index — the largest 500 companies in America.
How come? Because the market capitalizations of the Magnificent Seven dwarf those of the other global behemoths in the index such as Procter & Gamble, JP Morgan Chase, Exxon, Walmart and so on.
Remarkably, the five largest companies in the Magnificent Seven make up over 25% of the value of the entire S&P 500 index. All in, the Seven account for 30% of the index. And because America’s stock market is so huge, the S&P 500 makes up around 70% of those popular global index trackers, those tracking world stock markets in aggregate.
Meaning that just seven companies — all in broadly the same industry — are powering the pensions and life savings of significant numbers of investors.
Which should make many such investors rather uncomfortable, if they’ve got any sense. An index tracker is supposed to deliver cheap diversification — not extreme concentration risk.
Make your own decisions
Here at the Motley Fool, we believe that investors should control their own financial destiny, making their own investing decisions, rather than relying on costly fund managers and financial advisors.
That’s been our ethos right from the beginning, in the early 1990s.
Betting your prosperity and retirement savings on the Magnificent Seven is great, if that’s what you want to do. But don’t get sucked into doing so by default.
