Why the stellar performance of the magnificent seven makes a case for index investing

You don’t have to get very far down the leaderboard to understand what has propelled the rally in U.S. equities this year. The top seven names, in fact, pretty much tell the whole story.

The so-called magnificent seven stocks were responsible for practically all of the gains in the S&P 500 index through the first half of the year. Widen the lens out to the entire world, and roughly 70 per cent of the net wealth created by stock markets globally was driven by this handful of tech behemoths.

To call the magnificent seven stocks dominant is an understatement. Apple Inc. AAPL-Q alone has a market capitalization of US$2.8-trillion, which is larger than the entire S&P/TSX Composite Index. Take what is encompassed in the Canadian benchmark – the big banks, the vast oil and gas sector, the mining and metals complex, the rails and telecoms, the tech and consumer industries – and all of it combined is dwarfed by the omnipresent smartphone company.

Factor in the other stocks at the top of the U.S. market – Microsoft Corp. MSFT-Q, Alphabet Inc. GOOG-NE, Amazon.com Inc. AMZN-Q, Nvidia Corp. NVDA-Q, Meta Platforms Inc. META-Q and Tesla Inc. TSLA-Q – and together they comprise about 28 per cent of the S&P 500.

If you’re a stock picker, almost nothing else matters right now than this tiny basket of huge stocks. Active managers of U.S. stock portfolios have seen their performance against the market largely reduced to their calls on the magnificent seven.

How can any investor expect to have an edge over the rest of the market when it comes to these stocks? After all, they are some of the most-watched and heavily traded equities on the planet. Not to mention the fact that these are highly correlated names that tend to move up and down in unison.

In investing, as in life, if you can’t beat ‘em, join ‘em. This is the basic idea behind passive investing. A diversified index fund lets you essentially buy into the entire market without having to pick the winners.

This year makes an unusually strong case for a broad index approach, which may seem counterintuitive. Why would you want to be forced to own legions of losing stocks when the market rally is so heavily concentrated in a small core of elite names?

This is why the investors and funds that gravitate toward a passive approach are sometimes collectively disparaged as “dumb money.” It doesn’t pretend to have insight into how to beat the market. And it isn’t directed by any conviction about the probable future returns of any one company versus its competition. It simply seeks the benefit of diversified, low-cost exposure to the entire economy, or at least the close approximation of the economy represented by the stock market.

A common criticism of passive investing is that it’s inflexible. You may end up highly concentrated in the best performing sectors. And you are essentially forced to buy high. An index like the S&P 500 is weighted by market capitalization, meaning each company’s share of the index is tied to its valuation. It follows that overvalued companies have larger weightings in the index than they should. The larger the weighting, the more passive money flows to that stock.

Passive investing may be “dumb” in a literal sense. But it is also the only way to ensure that you will always own the hottest stocks of the moment. That arguably outweighs the downside of an index fund strategy.

The performance of the magnificent seven this year is an extreme example of narrow leadership. But it isn’t as much of an anomaly as you might think.

The stock market has proven itself over the decades to be a compounding machine. In the case of the S&P 500, the average return has been roughly 10 per cent per year dating back nearly a century. The average stock, on the other hand, has a much different track record.

Research by Hendrik Bessembinder, a finance professor at Arizona State University, has shown that most stocks fail to outperform Treasury bills. Looking at returns for more than 64,000 common stocks from 1990 to 2020, 55 per cent of U.S. stocks and 57 per cent of non-U.S. stocks fell short of the return on one-month Treasuries over their lifetimes.

What’s more, a remarkably thin subset of market leaders has proven responsible for delivering the returns that investors have come to rely on. Over that same 30-year timeframe, stock markets globally generated roughly US$75-trillion in wealth. Half of that wealth was created by the best-performing 0.25 per cent of firms, or one in 400. And the top 2.4 per cent of stocks accounted for all of the net global wealth creation.

The research highlighted the long odds facing stock pickers. Can you consistently identify the tiny minority of stocks that will fuel the entire market? Can you find the needle in the haystack? Or, to paraphrase the index-investing pioneer Jack Bogle, should you just buy the haystack?

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