The Bottom Line
- Over the past five years, the S&P 500 generated a very impressive 14.6% average annual return1—which could easily tempt investors to take a rosy view of what strategies that track the index could provide going forward .
- But no party goes on forever, and it’s important to remember that index strategies also expose investors to the full impact of any future pullback.
- That’s worth considering given that recent market gains have displayed very narrow leadership. In the S&P 500, a small number of companies (primarily technology firms) that are heavily weighted in the index have driven much of the return.
- That underscores the concentration risk inherent in market-cap weighted indexes like the S&P 500 when specific companies or sectors become overvalued and thus susceptible to reversals—or may simply offer less future potential than companies with lesser weightings.
- Active strategies, of course, can provide a useful counterpoint to index strategies because they can underweight (or avoid altogether) stocks at risk due to elevated valuation and overweight those that appear undervalued relative to their future prospects.
- Such an approach often takes the form of a concentrated, but still diversified portfolio, which allows a manager to thoroughly understand each company, which leads to a high level of conviction about each investment.
- This approach is well suited to a long-term investment time horizon and a low turnover ratio, two factors historically associated with solid long-term performance.
1 Source: Bloomberg, as of 6/30/17.