Are Advisors Rethinking Index Investing?

Concerned about an AI bubble? Sign up for The Daily Upside for smart and actionable market news, built for investors.

Indexes don't play favorites, but clients might ask you to.

As sub-categories of various technology sectors (ahem … artificial intelligence) continue to dominate stock market performance, financial advisors are starting to question the pros and cons of passive broad market index investing. While the longer-term perspective has favored low-cost index funds over bull market periods, more recent market volatility and lopsided performance by select sectors has advisors taking a closer look at what's inside ETFs, like market giants the Vanguard Total Stock Market Index Fund (VTI) and the State Street SPDR S&P 500 ETF Trust (SPY). While those funds have bargain basement expense ratios of 3 basis points and 9 basis points, respectively, low cost can come with tradeoffs when it means owning losers in the index right alongside winners.

"The setup that made indexing nearly unbeatable for 15 years was the internet era's tailwind of cheap money, deep liquidity and a tide that lifted almost every boat, but AI may not be that kind of tide," said Haley Schaffer, founder and managing partner at Waypoint West. "As AI reorders industries, the winners and the disrupted end up sitting in the same index, and cap-weighting makes you hold the losers all the way down," she added. "That widening gap between the companies that adapt and the ones that get displaced is what brings selection back into play, and not just stock by stock, but also where you allocate, which sectors and which geographies."

Sign up for The Daily Upside at no cost for premium analysis on all your favorite stocks.

READ ALSO: SEC Is Revamping Earnings Season. Will Companies Really Ditch Quarterly Reports? and Inside Wall Street's Leveraged ETF Frenzy

Everything, Everywhere, All at Once

Discussions of active management and individual stock selection go against the grain of what much of the financial planning industry has been riding on for decades, as the broader financial services industry cranked out cheap beta in the form of ETFs and mutual funds that seemed to package just about everything into a passive index.

"When dispersion runs this wide, the choices start to matter again instead of getting averaged away," said Schaffer. 

Any index made up of hundreds of underlying companies will always have performance dispersion, but sometimes the extremes are too much to ignore:

• Inside the S&P 500, for example, you have a stock like Sandisk up more than 725% this year. 

• Micron Technology has climbed more than 280% as part of an index that has gained only about 9% over the same period. 

• But on the other end, there are laggards like Nike, down 35%, and Zoetis, down nearly 40%.