Index vs active investing: Is your portfolio really diversified?

Index investing has become an increasingly popular way to invest, and it is easy to understand why. Index funds offer a simple, low-cost way to invest across a broad range of companies, and strong recent performance has only added to their appeal.

Much of that performance has been fuelled by the extraordinary run of some of the world’s biggest technology and AI companies. But as their influence on major global indexes has grown, I think now is an important time for investors to consider what they actually own.

Why an index isn't always as diversified as it seems

Holding an index fund might give you exposure to hundreds of companies, but that doesn’t necessarily mean your money is evenly spread between them – or that your portfolio is as diversified as you might think.

Many major indexes are weighted according to company size, meaning the biggest companies make up a greater proportion of the index. As those companies grow, so does their influence on how the index performs – and the amount of your investment exposed to them.

This is where the idea of passive investing as a ‘neutral’ choice becomes more complicated. In a standard, passive global allocation, roughly 64 cents of every dollar is currently invested in US equities.

A passive global allocation today isn't truly neutral. It is a concentrated position in the US, particularly large-cap growth. While many clients believe they're broadly diversified, they're often unintentionally exposed to a single market, a narrow set of companies and a specific style bias.

There is an important distinction between where a company is listed and where it does business. Many of the largest US-listed companies operate globally and earn substantial revenue from markets around the world.

Their economic exposure – where their business activity and earnings actually come from – therefore extends well beyond the US. While this provides some diversification, it doesn't eliminate the underlying concentration risk.

When a relatively small group of large US-listed companies makes up a significant share of an index, investors can still find themselves more heavily exposed to the same companies and investment style than they realise.

Why technology and AI matter

The concern isn't necessarily exposure to technology or AI itself, but how much of that exposure investors may already have.

When you invest passively, you generally accept the weightings of the index you track. As particular companies become larger, you automatically own more of them. The index does not make a judgement about whether a company has become expensive or whether one sector has become too dominant within your portfolio.

That doesn't mean abandoning passive investing altogether but looking beyond the companies that have already driven much of the market's recent growth. The role of active management is less about increasing AI exposure and more about diversifying it.

The aim isn't to move away from AI, but to avoid relying too heavily on the handful of companies currently dominating the index.

Over time, the benefits of AI are likely to extend beyond today's major technology companies, as businesses across a wider range of industries adopt and benefit from the technology.

Where active investing can play a role

Active investing can offer something different. Rather than automatically replicating an index, an active investment manager makes deliberate decisions about which companies or assets to hold – and how much to invest in each.

That flexibility can be particularly useful in areas of the market where there is greater variation between companies and less research coverage. In less efficient parts of the market, such as small and mid-caps or emerging markets, there's greater dispersion, weaker coverage and more structural distortions, which creates a stronger opportunity set for active managers.

That doesn't mean active management is necessarily the better choice everywhere.

In highly efficient and extensively researched parts of the market, particularly US large-cap shares, the hurdle for active managers is high. Low-cost index exposure can therefore be the more reliable choice after fees.

Active and passive investing each have a role to play, depending on where they are best placed to add value.

Passive investments can still provide a cost-efficient core, while active strategies can be used selectively where there is greater opportunity to add value or diversify beyond the benchmark.

Within global equities, the approach includes tilting away from US dominance through active and passive strategies with broader geographic mandates.

The aim isn't to predict which country, sector or company will perform best next. It's to avoid relying too heavily on any one of them.

Look beyond the label

Index funds can be an effective and cost-efficient investment tool. But like any investment, it is important to understand what sits underneath the label.

A portfolio can contain hundreds or even thousands of companies and still be heavily influenced by one country, sector or group of very large businesses.

The current market presents an opportunity to look beyond the companies that have led recent returns. By considering opportunities across different parts of the market, investors can be more deliberate about where they take exposure, rather than simply following where an index has become most heavily weighted.

If you’d like to understand what this means for your own investment strategy, speak to your Apt adviser.

General Advice warning

The information in this blog does not constitute financial product advice. The information is of a general nature only and does not take into account your individual objectives, financial situation or needs. It should not be used, relied upon, or treated as a substitute for specific professional advice. Apt Wealth Group of Companies including Apt Wealth Partners (AFSL and ACL 436121), Apt Wealth Home Loans (powered by Smartline ACL 385325) and Acceptance Finance (ACL 391715) recommends that you obtain professional advice before making any decision in relation to your particular requirements or circumstances.