Index Investing, Once Riding High, Now Facing a Crashing Wave

You’ve probably been told a lot lately about the simplicity and safety of index investing. For years, it felt like we were riding an ever-rising tide, with market indexes consistently delivering ever higher returns. The allure was strong: low fees, instant diversification, and the comforting notion of simply mirroring the market's overall performance. The major banks and brokerages enthusiastically steered investors toward these passive vehicles, touting their low cost and simplicity. It was going to be a smooth sail on a calm sea.

And for a while, it worked beautifully. The rising tides of globalization, cheap money and cheap energy brought in cheaper goods, expanded markets and worked to inflate asset prices across the board. Index funds captured this rising tide, delivering seemingly effortless gains. It felt like a financial panacea, a way for everyone to participate in the market’s bounty without the perceived risks and costs of active management.

However, market conditions change swiftly, and the recent market tumult feels less like gentle waves and more like a full-blown tsunami. Investors who had comfortably anchored their portfolios to index funds are now finding themselves tossed about by violent market movements, down 10% one day, up 5% the next, leading them to question the very principles they had come to rely on. The seemingly invincible upward trend has turned, revealing the inherent vulnerabilities of a strategy that thrives in calm markets but struggles when the storm hits.

The Siren Song of Passive Investing: Low Costs and Lighter Regulations

The rise of passive index investing was fueled by the compelling narrative of lower costs and lighter regulation. Active management, with its teams of traders and analysts often comes with higher expenses. Banks and brokerages were quick to capitalize on this cost-conscious sentiment, aggressively promoting index funds and Exchange Traded Funds (ETFs) that track indexes. In 2023, passively managed funds surpassed actively managed for the first time. The message was clear: why pay more for active management when you can capture the market’s average return for a fraction of the price?

Assets Under Management - Passive vs Active funds

Furthermore, the regulatory landscape often favored passive investing. With less active trading and decision-making involved, index funds typically face lighter regulatory burdens compared to actively managed funds. This operational efficiency further contributed to their lower cost structure and appeal to large financial institutions looking to scale their asset management businesses. It was a win-win for the providers: attract massive inflows with a simple, low-cost product and navigate a less complex regulatory environment. Investors, in turn, were drawn to the seemingly transparent and cost-effective way to participate in market growth.

Concentration at the Crest: The Few Lifting the Many

However, beneath the surface of broad market gains, a more nuanced picture is emerging. The returns of major indexes like the S&P 500 have become increasingly concentrated in a handful of mega-cap growth tech stocks.  These market behemoths, fueled by the trends mentioned earlier, have experienced exponential growth, disproportionately pulling the entire index higher.

Consider these examples:

1. The Tech Titans: Companies like Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN) became dominant forces in the S&P 500. Their massive market capitalizations meant that their positive performance had an outsized impact on the index's overall return. For years, these stocks were seemingly unstoppable, contributing significantly to the index's gains.

   
   

2. The FAANG Frenzy (Meta, Apple, Amazon, Netflix, Google): This group, and its subsequent iterations, represented the high-growth, innovative segment of the market. Their stellar performance heavily influenced index returns, often masking the more tepid performance of other sectors within the same index.

   
   

3. The Semiconductor Surge: Companies like NVIDIA (NVDA) and other key players in the semiconductor industry experienced explosive growth driven by technological advancements and increasing demand. Their significant weight in certain indexes meant their gains disproportionately benefited passive investors holding those funds.

   
   

This concentration meant that the seemingly diversified returns of index funds were, in reality, heavily reliant on the continued success of a relatively small number of stocks. While this worked wonders during the bull market, it created a significant vulnerability: if these leading stocks falter, the entire index, and by extension, the portfolios of passive investors, could be significantly impacted.

A New Market, A New Era of Risk

The market forces that fueled the current bull market and the subsequent popularity of index investing have largely reversed course, creating a significantly different and arguably more perilous environment for  investors.

Trade wars signal shifting fundamentals in world trade

• The Retreat of Globalization: The era of seamless global trade and interconnected supply chains is facing headwinds. Geopolitical tensions, trade wars, and a renewed focus on national security are leading to supply chain diversification, re-shoring, and increased protectionism. This reversal of globalization serves to rapidly increase prices, reducing the profitability of the multinational corporations that were key drivers of index returns.

• The End of Cheap Energy: The era of abundant and cheap energy is arguably over. Geopolitical instability, the transition to renewable energy (which requires significant upfront investment), and supply constraints are contributing to higher energy prices. This can squeeze corporate profits and increase inflationary pressures, impacting overall market performance.

  
  

• The Tightening of Cheap Money: Central banks around the world have aggressively raised interest rates to combat inflation, marking the end of the era of ultra-low interest rates. This tightening of monetary policy increases the cost of borrowing for businesses and consumers, dampens economic growth, and puts downward pressure on asset valuations. The very cheap money that inflated asset prices for years is now receding, leaving index investors exposed to potentially significant corrections.

  
  

These reversed currents create a far more complex and volatile market environment. The rising tide that once effortlessly carried index funds higher is receding, leaving many passive investors exposed to a market undergoing a fundamental shift. The assumption that broad market returns will continue their upward trajectory, a core tenet of passive investing, is a luxury investors can no longer afford.

Index Investing in Different Markets

The beauty of index investing lies in its simplicity. When the overall market is trending upwards, an index fund, by mirroring that trend, easily delivers positive returns. Diversification across a broad range of stocks in the index smooths out individual company volatility, and the rising tide lifts all companies, or at least most of them.

However, the limitations of passive investing become starkly apparent when the market turns – in bearish or range-bound markets.

• Bearish Markets, where the overall market is declining, an index fund simply mimics that decline. With no active management to identify the worst-performing sectors or to pivot to more defensive positions, investors are fully exposed to the market’s downturn. The diversification that seemed like a strength during the bull market now offers little protection against broad market capitulation.

  
  

• Range-Bound Markets, that move sideways within a defined range, index funds essentially tread water. They capture the ups and downs, but without active management to identify specific opportunities for growth or to capitalize on relative value, returns are lackluster and frustrating. Expending lots of energy and angst but going nowhere.

How Long Can You Wait?

When markets sell off from their highs it's rapid, often eroding years worth of gains in months.  Investment advisers start telling their clients to think long term, but how long can you wait? After reaching all time highs, markets often have long periods of stagnation. 

Looking at other major stock indexes, European stocks reached their all time peak in January 2000 and haven’t come back in 25 years; Japan peaked in 1990 and is still little over half of its peak level 35 years later. 

Europe's 25 years of stock return stagnation

Japan's Lost Decades - 35 years since the peak

Our latest bull market, birthed under the Obama administration in March of 2009 has lasted the longest and delivered the biggest returns on record.  But as the disclaimer states: “past performance is not indicative of future results”.  Especially when the underlying conditions for it have receded.  Savvy US investors shouldn't take the past for granted.

A Compelling Call to Action: Navigate the Storm with Active Management

The era of passive investing in a calm market is over. We are now in a period of active markets, characterized by significant volatility, shifting trends, and divergent performance across sectors and individual companies. In such an environment, the broad-brush approach of index investing leaves you at the mercy of the overwhelming forces, with no professional guidance and little ability to steer or seek shelter.

Active markets demand active management. The ability to strategically allocate capital, identify emerging opportunities, mitigate risks, and adapt to rapidly changing conditions becomes paramount. At Ronin Trading Partners, our team of independent investment managers possesses the expertise, agility, and in-depth market knowledge required to navigate this economic storm.

We offer:

• Bespoke investment strategies tailored to your individual risk tolerance and financial goals.

• Proactive portfolio management designed to identify and capitalize on market inefficiencies.

• Disciplined risk management strategies to help weather market volatility and protect your capital.

• Personalized guidance and transparent communication to keep you informed and empowered.

  
  

Don't let the tsunami of today’s current market volatility overwhelm your investment portfolio. The time for passive investing is over. Contact Ronin Trading Partners today and let our team of experienced, independent investment managers help you actively navigate these turbulent waters and chart a course towards your financial objectives.