Index Funds and the Duty to Diversify

Since their birth in 1976, equity index funds have become very popular with investors by offering maximum diversification – and thus minimum risk – with management fees that are far lower than traditional stock-picking mutual funds. As of year-end 2023, index funds held 18% of the US stock market as compared to 13% held by actively managed mutual funds. But pundits and politicians have decried the size of index funds as a threat to corporate governance and market efficiency.

Most critics focus on the failure of fund managers to vote with care and otherwise to engage with portfolio companies. They also see index fund passivity as free riding on the research of others – as exploiting market efficiency to cut prices and siphon off the business of funds that do do their homework.

No doubt fees matter. On average, actively managed funds charge fees of about 0.65% annually while index funds charge about 0.05% annually. If stocks return 6% annually, $1000 invested today in an index fund (at a net return of 5.95%) would grow to $1782 over the next ten years while the same amount invested in an actively managed fund (at a net return of 5.35%) would grow to $1684 over the same period. And these figures do not reflect the even bigger difference made by the promotional fees often paid by actively managed funds and the higher taxes and commissions generated by more active trading (which could easily add up to a further 2% reduction in return).

More important than low fees, index funds offer maximum diversification – and thus minimum risk – without any reduction in expected return. The efficient market has nothing to do with it. Indeed, indexing would be even more compelling if the market were less efficient – if market prices are often wrong. The prospect of the same return at less risk alone would be enough to attract many investors. So lower fees are nothing but gravy. Moreover, an index fund investor can actually achieve a higher long-term rate of return than an investor who chooses a riskier fund even though both funds offer the same average annual rate of return. Although this may sound too good to be true, it is a straightforward implication of compounding. And to add insult to injury, index investors ultimately drive stock prices higher: They are willing to pay more for stocks because they assume less risk. Indeed, increasing diversification has accounted for about 0.62% of the 7.23% price return on stocks since 1930. As a result, stock-picking investors pay more than is justified by the returns they can expect.

Still, how does one select portfolio stocks without evaluating individual prospects? It may be just as costly to construct the optimum portfolio as is it is to pick winners. Clearly, one important factor is the number of stocks to be included. Studies find that one can eliminate most company-specific risk with a portfolio of twenty stocks, which suggests no more than 5% in any one stock. But a portfolio of twenty different tech stocks is over-exposed to industry-specific risk, entailing some risk that can be avoided with more diversification. So diversification depends on both the number of different stocks and the distribution thereof over various industries. How do we know which stocks to include – and in what proportions – so as to be as diversified as possible?

The market provides the answer. The value of a company – its market capitalization – is  proportional to expected returns. So by holding (say) the 500 largest stocks in proportion to the market capitalization of each, investments are distributed according to an impartial assessment of business opportunities economy-wide. It is the wisdom of crowds at work. Thus, a capitalization-weighted index such as the most widely followed version of the S&P500 (SPX) holds ten times as much stock of a company worth $100B as it holds of a company worth $10B.

The problem is that as of year-end 2024 Apple accounted for 7.60% of the value of SPX (a record high percentage for any one company) while Nvidia accounted for 6.61% and Microsoft accounted for 6.29% thereof. But even if one invests in the entire US market – the S&P Total Market Index with 3999 companies – Apple still accounts for 6.26% of index value. S&P attempted to address this problem in April 2024 by launching a new version of the S&P500 wherein constituent stocks are capped at 3% of aggregate index value. But it turns out that the new 3% capped index underperforms SPX.

Another alternative is to invest in the equal-weight version of the S&P500 (SPW). While holding SPW avoids investing almost 8% in Apple, it also means that 50% is invested in the 250 smallest index companies. While smaller companies generate higher returns, the logic of investing just a little bit in the very largest companies is unclear – and doubly so because the individual stocks composing the S&P500 are chosen according to size in the first place. Moreover, investing in small-company stocks entails subtle costs that may outweigh the benefits of better diversification. Turnover for SPW – the trading required to keep the portfolio balanced – was a whopping 21% compared to 3% for SPX in 2024. And small stocks are more expensive to trade because they are less liquid and because trading is more likely to affect price.

In the end, the data suggest that investors should stick with SPX. The fact that three stocks therein each exceed 5% of index value is likely an anomaly. In 35 out of the 45 years since 1980, no one company exceeded 5% of the value of the entire index. During that same period, the largest company in the index accounted on average for 3.83% of index value. The upshot is that one needs to invest in about 500 stocks BOTH to hold a size-weighted portfolio AND to invest no more than about 4% by value in the largest stocks therein. Thus, SPX appears to be the Goldilocks Portfolio.

Still, what about market efficiency and corporate governance? The answer is that index fund managers are fiduciaries who have no discretion in choosing or trading portfolio stocks. So research is a literal (and legal) waste because the fruits thereof can have no use. To expend fund resources thereon or to charge the fund a management fee bloated by such costs would be a per se breach of fiduciary duty. Moreover, overinvestment in research is just as worrisome as underinvestment. Thus, index funds make the market more efficient by affording investors a choice whether to pay for research.

The same logic applies to voting and other forms of engagement with portfolio companies. Presumably, the purpose of engagement is to enhance performance. But engagement is expensive. It requires delving into operational details of individual businesses. For index fund managers, whose portfolios are hedged by virtue of being fully diversified, it makes no sense to devote fund resources to such ends. Moreover, index funds that follow the sensible practice of mirror voting – voting fund shares in proportion to the votes of other shares – have the effect of enhancing the voting power of actively managed funds (including hedge funds), which increases the voice of stockholders who have strong opinions. In other words, index funds actually  address the separation of ownership from control.

The bottom line is that ordinary investors who choose to invest in equities should do so by investing in an index fund. To be sure, individual investors are free to invest their own money however they want. But it is not too strong to say that it is irrational for an ordinary investor not to invest in an index fund. It follows that investment advisers who cater to ordinary investors are required by fiduciary duty to recommend indexing. This is a radical proposition. It implies that much investment advice borders on fraud. It also helps explain why the securities industry has so vigorously opposed regulations that would deem broker-dealers to be fiduciaries. And it certainly explains why so much money is now invested in index funds. In short, index funds have made the financial world a much better place than it was in the past. Efforts to control their further growth and evolution should be undertaken only with an abundance of caution.

Richard A. Booth is the Martin G. McGuinn Professor of Business Law, Villanova University Charles Widger School of Law.

The full paper is available here.