For a long time, I was very sceptical of index funds and of passive approaches to investing built around them.

This is mostly because of how receptive I have been to arguments concerning 1) high levels of concentration in some indices and 2) high market valuations versus history.

I am writing this article today because I’m not sure those things should have concerned me as much as they did. At least not to the extent that made me shun an indexed approach to investing for many years.

As we’ll see in a moment:

  • High levels of concentration in a specific market don’t necessarily lead to high concentration in a portfolio of index tracking ETFs.
  • And while valuation is obviously important, common arguments on this basis can seem factually correct at the time but still be completely wrong.

Are indexed approaches too concentrated?

A common argument against index funds is that they are too concentrated.

This happens when a small number of companies obtain far higher market values than all of the other companies in their market. In turn, market-cap weighted index funds end up with a very ‘top heavy’ look to them.

You may hear about concentration in the context of individual markets like the ASX200 or S&P 500. Or you might hear about it in the context of global indices like the MSCI World being heavily exposed to one country.

Either way, the questions that critics will be asking here are the same. What if the dominant shares or countries don’t perform well? Doesn’t investing in concentrated index funds enhance the risk of poor returns?

These arguments can be convincing because they are supported by indisputable facts regarding the stock, sector and country weightings. And—let’s face it—some of those facts are rather sensational.

  • As of May 31 2025, just five stocks in the ASX300—CommBank (ASX:CBA), BHP Group (ASX:BHP), CSL Ltd (ASX:CSL), National Australia Bank (ASX:NAB) and Westpac (ASX:WBC) – had a collective weighting of around 32%.
  • As of the same date, six stocks—Nvidia (NAS:NVDA), Microsoft (NAS:MSFT), Apple (NAS:AAPL), Amazon (NAS:AMZN), Meta (NAS:META), and Alphabet (NAS:GOOGL) – accounted for roughly 30% of the S&P 500 index.
  • The MSCI World ex Australia Index, which is commonly tracked by international shares ETFs in Australia, had a 72.7% weighting to US equities as of its May 31 factsheet.

With that in mind, you might expect that an indexed portfolio split mostly between Australian and International equities would be stacked to the brim with CBA, BHP, Nvidia, Microsoft and co. But is it really as extreme as that?

Concentration in a typical indexed portfolio

Starting my job in Australia involved choosing a super fund. I chose an indexed option that recently had the following allocation:

  • 35.74% in Australian shares
  • 42.5% in international shares
  • 6.36% in international small companies
  • 5.44% in emerging market shares
  • 10% in domestic and international fixed income

I built a portfolio in Sharesight using my super provider’s main ETFs in each asset class. I then ran an Exposure Report to see the underlying holdings. My top five exposures at the stock level came out as follows:

  • 4.03% Commonwealth Bank
  • 2.66% BHP
  • 1.95% NVIDIA
  • 1.92% Microsoft
  • 1.79% Apple

My exposure to the ASX200’s top five companies was under 11.5%, to the S&P 500’s top six less than 9%, and to US equities around 31%.

We’ll return to the US question shortly, but is that a crazy level of concentration at the stock level?

And—let’s be honest here—is it anywhere near the concentration that most stock pickers, who decry index concentration, have in their portfolios of individual shares?

I certainly don’t have many share investments under a 4% weighting.

Is US dominance an issue?

As we’ve seen already, US shares recently made up 72% of MSCI’s developed world equity index that excludes Australian stocks.

MSCI’s ACWI index, which doesn’t exclude Australia and includes emerging markets like China and India, had a weighting of 64% to US shares as of May 31.

That is a big chunk, and some will say it is a problem for passive investors. What if US stocks stutter and drag down the overall return? What if a weaker US dollar becomes a huge headwind for returns in Aussie terms?

Both of those things could happen. But then again they might not.

I’d also point out that by the late 1980’s, Japanese shares rose to over 40% of the ACWI before collapsing and going nowhere for the best part of 30 years. Returns from the ACWI have still been alright.

From the peak of the Japanese equity bubble in December 1989, the index fell 16.5% in 1990. But overall it advanced by 7.5% per year in US dollar terms up to May 31 2025.

That’s not bad, especially when you consider the starting point couldn’t have been much worse in terms of how the market dominating the index performed subsequently.

Even if US shares don’t do as well from here, then, there’s every chance something else—a resurgent Europe or China, perhaps—could take up some of the slack for those invested in global equity ETFs.

Are index funds causing concentration?

It’s also quite common to see index funds being blamed for high levels of market concentration. And to see warnings that index funds can be expected to fuel even more concentration in the future.

Elements of that could be true, but it’s really hard to know. There are other factors at play, like many huge industries today having ‘winner take all’ dynamics (sometimes on a global basis).

We have reached a situation, for example, where one company facilitates around 40% of all online shopping in the US. And where another company (singular) was estimated to have a similar share of worldwide digital advertising spend in 2023.

Have there ever been such big market shares in such big markets?

Blind buying by index funds and ETFs after inflows aren’t the only reason that companies like Amazon and Alphabet have a bigger market capitalisation than most other companies.

What about high market valuations?

I’d like you to imagine index fund scepticism as a campfire. If concerns over stock, sector and country concentration are the firewood, then concerns over valuation are like petrol.

They enhance the urgency of the other concerns and turn them into fear.

I am not here to say if major market indices look overvalued or cheap now. I am also not saying that valuation doesn’t matter to future returns—it clearly does. All I am saying is that the stats used to suggest that a stock market or individual share is ‘cheap’ or ‘expensive’ can be misleading.

The valuation argument, for example, often goes like this:

“A market index, let’s say the S&P 500, looks eye bleedingly expensive versus history. This is obvious when you look at its trailing and forward P/E ratio versus history. At such a high valuation, buying an index fund is risky. Smart investors should avoid passive vehicles and find safety in cheaper corners of the market.”

The market’s valuation today isn’t being considered on an apples to apples basis, though. It is being compared to old iterations of the index.

Many of the companies dominating US indices today—I’m thinking mostly about network effect beneficiaries and sticky software players here—rank among the best and widest moat businesses that ever existed.

Look back in time—into the sample from which average P/E is calculated—and those companies and their exceptional business models disappear. In many cases, to be replaced by a greater weighting for banks and energy companies. For poorer businesses.

I am not saying there weren’t fantastic companies among the S&P 500’s biggest names in previous eras. On a weighted basis, though, surely its modern incarnation is among the highest quality ever. Maybe the S&P deserves a higher P/E ratio versus history.

I would put more weight on historical valuation levels when the weighted quality and growth prospects of a market index is similar (or worse) compared to the past. Today’s ASX300 may fall into that camp.

Cheaper than they looked

While we are on the topic of valuation multiples, remember they are not a valuation in themselves.

Despite this, their status as an indisputable fact or data point is often used to make a convincing case that something is cheap or expensive. Let me take you back to 2017 to see what I mean.

I chose 2017 because it is the earliest memory I have of being worried about valuations in major stock market indices and some of the biggest tech stocks in them.

Microsoft traded on a P/E of 30 in December 2017 while the broader market had a P/E of 25 and a historical average much lower than that. But even if Microsoft looked expensive on trailing or short-run forward metrics, it was not expensive. Far from it.

With hindsight, it was actually dirt cheap relative to what mattered—the future. Microsoft’s market cap at that time was around $600 billion. In fiscal 2024 alone, it raked in $100 billion of operating profits, with more double-digit growth expected ahead.

Meanwhile, Alphabet had a P/E of 35 and a market cap of $740 billion in December 2017. Expensive, perhaps, until you realise that in fiscal 2024 it also reported roughly $100 billion in profits—only after tax this time.

This is why a lot of so-called value investors missed big tech. And it’s why many ‘value conscious’ investors might have been scared away from buying index tracking funds at a great time to do so.

An even bigger risk?

This brings us to something that could be a bigger risk than concentration or historical valuation: missing out on the market’s biggest winners.

In a famous study, Henry Bessembinder showed that most US stocks deliver dreadful long-term returns, and that the bulk of long-term market returns were driven by a tiny subset of shares.

This study can be used by passive sceptics and their friends on the other side of the argument. One might point out that most of the investments held in an index fund will ultimately be rubbish. The other will highlight the risks of not guaranteeing exposure to the small number of winners.

The second point reminds me of Wayne Gretzy’s famous line on skating to where the puck is going to be. Only not in the way you might expect.

Many stock pickers think this quote applies to them—trying to hold the cheapest stuff before it gets less cheap. But, in my opinion, passive investors do it better. Why? Because they do it without needing to make a correct prediction.

As long as the companies are listed, the passive investor is positioned to benefit from whatever winner or trend emerges next. By owning the entire haystack, so the saying goes, they can be sure to have the needles in there somewhere.

As for the potential for many of the investments in an index to be rubbish, what about the potential for picks in a portfolio of individual shares to be rubbish too?

Trade-offs, not absolutes

In case you think I’ve gone full Boglehead on you, around 80% of my total retirement pot is still in a portfolio of individual shares.

The truth is, I like owning pieces of businesses. You aren’t any less of a business owner if you happen to own stocks through an index fund, but it just feels more real to me when I pick and own the shares individually.

I also get a buzz from getting to know a business and finding that its shares 1) seem to be a good fit for my strategy and 2) seem to offer good enough value to deliver the returns I need over time.

At the same time, though, having more of my retirement pot in index funds than ever before has been eye-opening. Mostly because of how easy I find it to leave this portfolio unwatched—something I’d love to do with my portfolio of stocks too.

As with everything in investing, weighing up different approaches is not a case of one being right and the other being wrong. It is more a case of considering the trade-offs of each and deciding which ones you can live with.

As it turns out, I can live with the trade-offs of a passive approach far more than I ever thought possible.

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