Why a passive approach may be exposing you to more risk than expected

The active versus passive debate is becoming an ever more popular topic – especially on the global front. But what if the concept of tracking an index at a “low cost” is not achieving what you were planning any more? It is important to analyse the real cost and downside risk that potentially comes with this approach.

Passive investing and its role in a portfolio definitely have an upside from a costing perspective. It should, however, be analysed holistically within a portfolio – and whether you are still achieving the overall goals within your strategy.

If you were to simply track the S&P 500 Index, this is what it would look like today. The Magnificent 7 – Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta – currently make up 28.1% of this index, up from 15% five years ago (28 August 2023, Ninety One weekly update).

• The Magnificent 7, a handful of technology stocks, are up an incredible 54% this year.
• Meanwhile, the remaining S&P 493 is up just 4%.
• The same stocks accounted for 75% of Nasdaq’s gain this year.

Yes, you would have enjoyed an incredible return by simply tracking this index for the past year. But is the downside risk to almost 30% of your portfolio also accounted for? Currently, there are a few risks involved with simply tracking an index – concentration risk, geographic risk and sector risk. I would recommend following a more diversified approach with these components and combining different investment styles within a portfolio.

I have compared the S&P 500 index with the PSG Wealth Global Creator Fund of Funds (USD). The PSG portfolio is a multi-manager portfolio, including managers following both an active and a passive strategy. (This portfolio is only available for clients of PSG Wealth advisors).

Let’s address the current risks of simply tracking the index.

The concentration at the top of the index is higher now than before the dotcom crash, which is something to be aware of.

Source: PSG Wealth

The returns of the above-mentioned companies benefitted significantly from the meteoric rise in stock prices from the perceived future benefit of AI in these businesses’ operations. There is an argument to be made that much of the future return has now already been priced in at quite high anticipation of future growth.

There is more downside risk now in these companies than earlier in the year.

• In an environment where interest rates are higher, and inflation is higher for longer, these growth companies are at serious risk of volatility as small movements in expectations will have large impacts on their valuations.
• Additionally, high interest rates and higher inflation make it a more difficult operating environment for tech companies, as they don’t always have pricing power over their goods like businesses in the healthcare environment that determine their pricing and are more inflation resistant.

I would make the argument that stock selection is now more critical than ever: selecting stocks that can weather the inflation and high interest rate cycle storm.

In any well-diversified resilient approach to a portfolio, stock picking becomes essential at some point to ensure you are also diversifying across sectors and including the timing when a specific sector/equity might have reached its potential or is simply becoming too expensive or too risky within a holistic approach.

Concentration risk of the S&P 500 vs a diversified offshore approach

Source: PSG Asset Management

We also see that the fund of funds is more diversified than the exchange-traded fund (ETF) in terms of sector breakdown.

S&P 500 sector breakdown

Source: PSG Asset Management

PSG Wealth Global Creator Fund of Funds: Equity sector allocation

Source: PSG Wealth and Morningstar

When constructing a resilient, “all-weather” portfolio, it is recommended to diversify optimally. This can ensure your portfolio has downside protection throughout different market cycles and also provides a more consistent return over the long term. I would recommend working with a wealth advisor where a focused strategy can be taken and actively managed.