Over the last few years the popularity of index / passive investing has absolutely exploded. It is hard to argue with the data which clearly shows how active management has failed to keep pace with a simple broad market, non-managed basket of stocks such as the S&P 500.

Above is a screen from Bloomberg displaying the total number of funds which have provided out performance over a 3 -year time horizon

Add to this the fact that without an active fund manager the fees for passive investing are much less. With folks like Warren Buffett championing the likes of Vanguard and a simple S&P 500 it is not surprising to see the  historic rush by investors into passive index funds. (data) I’m proud that long ago our firm adopted a passive approach when allocating funds, opting to use an index fund as a core position within our overall strategy. Now, however, I’m beginning to see a problem arise that may result in a surprise for so many folks who believe their buying a truly diversified basket of stocks. What was once extremely diversified is now concentrated in one sector that is arguably overvalued and moving higher simply due to the momentum of new money. Let me explain.

The S&P 500 is comprised of 11 sectors and is what’s called a market cap weighted index. What this means is that the weighting of any one stock and subsequently the overall sector, boils down to the market cap of that company and the cumulative total in market cap of all stocks in the index. Market cap is simply the price of a stock, multiplied by all shares outstanding. In simple terms, the higher a stock price travels, the higher its market cap becomes and thus the more weight it has in the S&P 500.

In the past this market cap weighted system worked so very well because as stocks and sectors come in and out of favor the index will naturally ebb and flow between groups of stocks, giving the investor continued rotation or systematic rebalancing. Over the last few years however, and 2017 in particular, this natural rebalancing has not been as efficient but rather the index has seen a significant shift into one sector. Technology, has started to take up more and more importance in the index due primarily in part to the incredible rush into the index itself.

At the end of the 2009, when the stock market began its most recent historic rise, the breakdown of the S&P 500 was as follows:

As you can see, technology stocks at the end of 2009 represented just under 20% of the total S&P 500. Furthermore, you’ll  note that there are only 10 sectors shown rather than 11 which is because it was only recently that the index added an 11th in Real Estate.

When we fast forward 7 years later, we see that not much has changed  in the overall index. While the tech sector has commanded a greater position, the actual movement from 19.85 to 20.77 is a 4.6% increase. Meanwhile we also saw a slight increase in the weighting of financials, health care and a significant jump in consumer discretionary stocks. Energy fell from 11.48 to 7.56. These shifts make sense consider the length of time and the natural movements within the sectors and stocks. Over a period of 7 years investors within this index would have slowly shifted from various sectors without having much concern for any lopsided diversification. 2017 has been quite different.

Above represents a snapshot of the same index just 8 months into 2017. What is astonishing to me is that in the course of 7 years technology exposure in the S&P 500 increased by 4.6% and in the last 8 months this exposure has jumped from 20.77 to 23.44 or an 11% increase.

Healthcare and financials still represent slightly under 15%, which is a healthy amount however my concern is that with such a large weighting in tech, should the sector begin to falter, the same momentum will transpire on the downside that we’ve seen on the upside.

Once again, it’s important to understand that whenever someone buys an S&P 500 index fund, each dollar will be split up as shown above. The compounding effect of more money pouring into these passive investments means that the allocation increases and overtime this sector weighting will continue to grow and grow.

I strongly believe that an investor can gain similar index exposure but remain a bit more in control of their investments by simply dividing their funds across the sectors themselves rather than one mutual fund or ETF.  Consider capping your tech exposure at 15% and maybe look at slightly increasing your exposure in other areas that may not be as overvalued such as energy or basic materials. While in the short term you may slightly underperform, especially if the tech sector continues to run, but in the long run you’ll be much more diversified and prepared for the next correction.