Individual stock pickers like Warren Buffett are increasingly looking like dinosaurs in a market that’s driven by investors scooping up passive exchange-traded funds that simply own the biggest stocks.
Investors are increasingly flocking to ETFs like the SPDR S&P 500 (SPY) and Invesco QQQ (QQQ), which both have a heavy concentration in a handful of tech companies. But is that setting up the Robinhood crowd for disappointment?
Some experts are growing increasingly nervous about the fact that Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Google owner Alphabet (GOOGL) and Facebook (FB) – the five largest stocks in the S&P 500 – have become so dominant.
Investors who are blindly scooping up ETFs because they believe they’re less risky than owning individual stocks could be in for a rude awakening.
“The extraordinary performance of a few large technology companies has some worried about the market’s concentration,” said Mark Hackett, chief of investment research with Nationwide, in a report this month.
Tech wreck could take down the broader market
Hackett noted the Nasdaq, home to many big tech companies, is now trading at its highest valuation (based on price and expected earnings for next year) since just after the great dot-com tech bubble burst in 2000.
That “makes the market susceptible to a hiccup in the technology sector,” Hackett added. Investors could be forced to sell top ETFs if any of the leading tech companies stumbles.
More actively managed funds, run by professional stock pickers like Buffett, tend to own a more diversified mix of companies in their portfolios. That helps limit the chances of losing a lot of money when one particular sector goes south.
Market veterans – those who remember firsthand what it was like when the Nasdaq plummeted more than 50% from its 2000 peak in a matter of months – are starting to see eerie flashbacks to two decades ago.
“There are clearly a lot of similarities between the market dynamics in the late 90s and current market dynamics. And, for those of us that lived [through] the bursting of the tech bubble, that’s disconcerting,” said Tom Essaye, editor of The Sevens Report investing newsletter.
Gold and bonds looking frothy as well
The rush into passive ETFs appears to be having an impact on other assets like gold as well, potentially setting up a bear run for the metal now that it has surged to all-time highs.
Many investors have been getting exposure to gold through the popular SPDR Gold Shares ETF (GLD) as well as passive funds that own both the commodity as well as gold mining stocks.
“Massive passive ETF gold ownership may introduce a period of irrational exuberance,” according to Cam Harvey, partner and senior advisor with Research Affiliates and professor of finance at Duke’s Fuqua School of Business.
The passive investing boom is even lifting prices in the usually more staid bond market.
“We believe prudent fixed-income investors will need to rely much more heavily on portfolios that can be both dynamic and active…as passive allocations appear more vulnerable to shocks than they have in years,” said Daniel Janis, senior portfolio manager at Manulife Investment Management, in a report last month.
Janis added that the corporate bond market in particular is much riskier now, mainly because companies with weaker financials have been able to binge on debt thanks to the Federal Reserve and other central banks around the globe keeping rates so low.
“Partly due to easy access to cheap funding, lower-quality companies have become ever larger segments of the market,” Janis said.
That could be bad news if there is a sudden wave of credit downgrades for riskier companies. Janis warns of “an unappealing domino effect,” ass many bond funds would be required to sell once things started to fall apart.
“The forced selling would lead to further price erosion and, as is often the case…those price declines would trigger waves of redemptions. Asset managers would be forced to raise cash to meet redemptions—and the cycle continues,” Janis said.