Author: Michael J. Francis, JD
Index funds make investing simpler and cheaper. But as money piles into them, investors need to understand the increasing risk they carry – and what they can do to manage this risk. In 2007, Warren Buffett famously bet a hedge fund manager that investing in the S&P 500 and holding it for 10 years would outperform his far more sophisticated and expensive hedge fund. He was right, and not just by a little, but by a lot. While index fund investing has helped millions accumulate meaningful wealth through low-cost broad market exposure, its growing popularity is creating new risks that investors should understand.
The rise of index funds in the past 50 years
Since their introduction over 50 years ago, index fund assets have grown exponentially. By June of 2026, index funds held more assets than actively managed funds, accounting for 53.7% of all fund assets according to Morningstar. In U.S. stock funds alone, index funds represented an even higher 63.8%. Most popular stock indexes, such as the S&P 500, are weighted by market capitalization. This means the larger the company, the greater the effect it has on the index’s performance.
Some investors misunderstand diversification
When investors hear “S&P 500,” many picture a diversified basket of 500 companies. While the number of companies is accurate, how fund assets are allocated among these companies has changed dramatically over time.
Over the past 50 years, the top 10 holdings of the S&P 500 have made up on average 23% of the fund’s total assets. Today, that number is close to 40%, a record level. That means today, nearly $40 of every $100 invested in an S&P 500 index fund goes into just 10 companies. The remaining $60 is spread over 490 companies.
As the amount of money flowing into S&P 500 index funds expands, it gets invested primarily in the funds’ largest holdings. The more that gets invested in these top holdings, the better they perform. The better they perform, the better the index performs. The better the index performs, the more money gets invested in them. You get the picture.
The growing risk of concentration and risk
Since so many of these top companies are connected to a similar technology or AI theme, the level of diversification obtained by investing in the S&P 500 index is at an all-time low. Why should you care? Because more concentration means more risk. The collapse of the tech stock bubble, from 2000 – 2002, helps illustrate this risk. During this period, the Dow Jones Industrial Average, with approximately 12% in technology stocks, fell 37%. The S&P 500, with approximately 33% in technology stocks, sank 49%, and the Nasdaq Composite, with 70% in technology stocks, dropped a stunning 78%.
Owning a well-known index fund does not automatically mean you’re properly diversified. Different indexes provide different exposures to risk. It’s your job to understand this risk and decide whether it fits your investment objectives.
Here are ways to reduce concentration, risk
If you determine the downside risk of your index-based investment strategy is getting larger than you signed up for, consider the following diversifying strategies to lessen your risk:
Value funds: Value-based index funds invest in companies that are inexpensive or undervalued when compared to other companies. These funds often hold companies focused on industries such as energy, financial services, consumer products, and industrials and are normally significantly underweight technology.
Equal-weight index funds: An equal-weight S&P 500 index fund invests the same amount in each of the 500 companies in the index. Instead of concentrating its assets on its largest companies, it spreads its assets evenly over all its holdings. An equal-weight fund requires more frequent rebalancing and therefore carries higher internal trading costs. In return, you own a fund that places a lot more emphasis on the performance of its smaller companies.
Non-correlated assets: The top holdings in most index funds share many of the same risk exposures because they are heavily linked to the AI buildout. There are two primary threats to this investment theme. Because of the extensive borrowing needed to finance the AI buildout, one risk is meaningfully higher interest rates. The second risk is Chinese competition that lowers the cost of compute and destroys the profit models these data centers were built on.
Short-term and floating rate bond funds provide protection from rising interest rates, and there are numerous international equity funds, including index funds, that can provide exposure to Chinese technology stocks.
Successful investing requires a focus on the future. Taking outsized risks can lead to a painful derailing of an excellent long-term investment strategy. Understand what you own, what risk exposures you have, and if needed, adjust your portfolio to maintain a risk profile you can live with.
The information contained herein is provided for informational purposes only and does not constitute legal, tax, or investment advice. The information provided is from sources we believe to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice.
