Index trackers provide cheap exposure to all the shares in a specific index – the FTSE All-Share index, the AIM 100 index, the FTSE 100, the FTSE 250, or overseas indices such as Japan's Nikkei 225 or America's S&P 500.
They are rightfully popular with certain types of investors – beginners, say, or those who don't want to spend a lot of time managing their portfolio, or those who want exposure to certain industries or countries.
But that doesn't mean they're a smart move for everyone. Many index trackers are suitable for income investors, for example. Indices include both income stocks and growth stocks, and passive investors often find the returns offered from growth stocks too small for their taste.
And recent days have highlighted the shortcomings of index trackers for investors who want to avoid unwelcome chaos in their portfolio calculations – those approaching retirement, say, or who want to close part of their portfolio to fund a large purchase.
Bumps in the road
Global markets got off to a rough start in August.
Japan's Nikkei fell 12%, before hitting some of that a few days later. Elsewhere, the fall has been extreme – or at least, extreme as I write these words.
But with Europe, the Far East and North America all showing falls in the 3–5% range, it's clear that traders are panicking.
Why, really? There are two things that seem to be conspiring to bring about this fear.
Scammers
First, some US economic statistics – particularly the unemployment numbers – have been interpreted by traders as indicating that the US may be very close to recession.
Personally, looking at the numbers, and looking at other explanations, I think those fears of a recession are overblown.
But markets, remember, are driven by emotions rather than facts. When traders are shaken, they will want to close their positions, rather than risk being dragged down by falling markets. Better to be safe than sorry, goes their argument.
Second, there was a sell-off in technology stocks: some technology stocks fell by around 30% – mainly semiconductor stocks. The UK's The cost of ARM sharesnow listed on the NASDAQ, instead of London, has fallen by a third in a month, for example.
And in recent days, the contagion has spread to mainstream tech stocks.
Pin, bubble, stab – and explode
Actually, what has happened is that some of the brilliance has come from artificial intelligence (AI). Semiconductor manufacturers – which make the special chips that power AI – are starting to get affected, as the hype bubble starts to melt.
America, Nvidiafor example, it was struck as ARM, whose shares have lost 30% of their value since the beginning of July.
Then it was the turn of companies trying to use those AI chips to actually use AI to provide AI-driven services and products – Microsoftthe owner of Facebook MetaOwned by Google Alphabets, and so on. Collectively, the companies in this AI Ecosystem are often referred to as the Magnificent Seven – Microsoft, Amazon, Apple, alphabet, MetaNvidia and Tesla.
Their share prices have fallen, as investors get the message that AI services and products will take longer to deliver than expected, and will be more expensive to develop.
The danger of concentration
Which are index trackers that track the broad based S&P 500 index of America – the 500 largest companies in America.
How? Because the Magnificent Seven's market capitalization is smaller than other global behemoths in the like index Procter & Gamble, JP Morgan Chase, Exxon, Walmart and so on.
Incredibly, the five largest companies in the Magnificent Seven make up more than 25% of the value of the entire S&P 500 index. In total, the Seven make up 30% of the index. And because the US stock market is so large, the S&P 500 makes up about 70% of those global index trackers, those that track the world's markets as a whole.
Which means that only seven companies – all in the same industry – enable pensions and life savings for significant numbers of investors.
Which should make many such investors uncomfortable, if they have any sense. An index tracker should deliver cheap diversification – not the risk of over-concentration.
Make your own decisions
Here at The Motley Fool, we believe that investors should be in control of their financial future, making their own investment decisions, rather than relying on expensive fund managers and financial advisors.
That has been our practice since the beginning, in the early 1990s.
Betting your prosperity and retirement savings on the Magnificent Seven is fine, if that's what you want to do. But don't focus on doing so automatically.
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