The Dividend Cafe - These Are Not Your Parents' Index Funds!

Episode Date: October 24, 2025

Today's Post - https://bahnsen.co/47Ly2Ab Understanding Index Funds and Their Evolution: A Comprehensive Analysis In this episode of the Friday Dividend Cafe, David Bahnsen, Chief Investment Officer of The Bahnsen Group, delves into the topic of index funds and their evolution over the years. He discusses the impact of index funds on the investment landscape, comparing their performance and risk profile to other investment approaches like dividend growth investing. David examines the significant growth in index fund ownership, changes in the composition of the S&P 500, and the implications of market capitalization-weighted indices. He also addresses common concerns, such as market liquidity, valuation risks, and the role of financial advisors in tailoring portfolios to individual needs. The discussion is aimed at providing a deeper understanding of the current dynamics in indexing and its relevance to both investors and financial advisors. 00:00 Introduction to Dividend Cafe 00:17 The Evolution of Indexing 00:59 Indexing vs. Dividend Growth Investing 03:39 Understanding Market Beta 07:27 The Role of Advisors and Fees 13:06 The Growth of S&P 500 Index Funds 22:35 Systemic Risks and Market Dynamics 31:13 Conclusion and Final Thoughts Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to the Friday Dividend Cafe. I am your host, David Bonson. I am the chief investment officer of the Bonson Group. And as the chief investment officer, I have a lot to say about investment-related topics like this one. And today, we are talking about index funds, indexing. How has indexing changed over the years?

What does it matter? What does it mean for our clients and the way we invest money? What does it mean for you? For people who actually own index funds, for people who don't own index funds. It's just a very comprehensive address of a subject that I think is extremely important to the overall world of investing.

We're going to dive into it a bit. This is a Dividing Cafe that I kind of wrote over the last couple of days that I thought was going to be a very short one and ended up being much longer. But there is a lot to dive into. You know, the first thing I kind of want to say is that I'm not about to go into a big screed on why I do not favor index investing as our approach. it is very true that I do not favor index investing. But this is not a let me talk my book session. Everything I do is sort of us talking our book. And that's a little bit different than the expression normally means. It can often mean someone being sort of annoying and pushing something they have to sell. But what I mean by everything I do is talking our book is that I'm always

going to be advocating for the things I believe. And what we do reflects what we believe. So if I didn't believe in what I was doing, there would be something wrong with me ethically. And if I do believe in what we're doing, then I guess it stands to reason I should talk about it every now and then. So yes, I use Dividy Cafe. I use things I write, things I speak, interviews I do, whatever the context or medium it may be, I'm talking our book. I'm advocating for the things that we believe. When it comes to an investment philosophy, what we believe is different than one that is favoring low-cost market beta over something more distinct. And what we believe that is distinct is obviously somewhat embedded in the name of this very communication, the dividend

Cafe, we have built our business around being dividend growth investors. And that's not a big secret. But when I address indexing today, I'm more speaking to some very interesting dynamics about indexing itself, regardless of how you want to contrast the investment approach of indexing to dividend growth investing. So this is less about let's contrast indexing to dividend growth and more just about the absolute state of indexing. And I think that, you know, the expression, straw man, when you misrepresent something you're going to criticize so that it becomes easier to critique, the opposite of that is to steal man something where you represent something very fairly so that the thing you're critiquing could actually recognize or agree with the way you've described it.

I think that the steel manning of equity investing done via indexes is to say that you are looking to get the lowest cost, lowest friction, highest ease in access, and avoid discussions of either overperforming or underperforming the market, because you would basically own the market. So you eliminate that human fallibility, or you eliminate the various things that should go into being above or below the market return when you're just simply replicating the market return and doing so at a very low cost. Beta does not cost a lot of money. And that's what we're referring to an investment terminology here is market beta. So beta can be bought cheaply. And that's the argument for equity indexes.

We're going to use the S&P 500 is the main example. Now, when I hear people talk about their portfolio, either underperforming or outperforming the market or wondering how a portfolio has done relative to the market, one of the challenges in the vocabulary is it's almost never the case that what is being discussed is a portfolio that is 100% in the market is being compared to the market, the S&P 500.

You're not merely often doing an apples to oranges comparison, but I like the expression apples to carburetors. It's not just two different fruits. It's a fruit and something else like an auto part. I mean, when you start mixing in bonds or when you start mixing in real estate or alternatives, or the stocks you own are themselves way outside of, let's say, the S&P 500, and you're talking about international or emerging markets or small cap or whatever the case may be, talking about how you under or overperform relative is a little bit questionable in the analogy.

Now, at a portfolio that owns various asset classes intended to decrease the volatility of the portfolio, which is generally why people own other asset classes, then the S&P 500, is one that is supposed to underperform in really good times because you took the foot off the gas of the beta of that market, the full exposure to market return. And anyone who wants double the return of the market can use leverage or additional beta to try to go capture that.

the reality is that most investors have some form of a diversified portfolio for the simple reason that, again, and there are exceptions, but most investors have various objectives, liquidity needs, income goals, risk tolerance, and appetite, comfort level with up and down volatility that makes their portfolio necessary to have something more than just the S&P 540. And so to then do a portfolio construction that is customized to all the different objectives and dynamics of a given investor, but then compare that tailored portfolio as if it were just the S&P 500 is just sort of stupid. But I would suggest that we still have the basic vocabulary out there of wondering how someone did compared to the market. Okay? So let's first put that on the table. But then let's evaluate this issue about the fee because a lot of the argument for the S&P 500 is that it can be bought very cheaply. And if one has an

advisor, you know, my company here, I'm sitting here talking and the Dividing Cafe comes to you from the Bonson Group and we are a wealth advisor firm and we charge fees to give advice. and we create very dynamic and customized portfolios along with a wide array of planning services and value we intend to offer through the relationship. So people can have their opinions about our fees and our services and they can have their opinions about the fees and services of any advisor. But presumably any advisor out there is charging a fee for the work that advisor does.

And so they use the S&P 500 as their investment tool, It's true that there may not be a fee related to that investment, but hopefully there is some fee so that that advisor is making a living and being paid for the value we presume that he or she is offering. And so because we don't charge fees per se for the investments, I don't know how to relate to that. The reality is if we only use the S&P 500 as an investment tool and we were, in relationship with the clients we're in and providing all the services we're in and again, whether it's us or any other advisory firm, a significant part of that is supposed to be in this behavioral advice and guidance when it is needed the most.

Trying to keep people from panicking at the wrong times and becoming overly euphoric at the wrong times. That tendency of human beings to make behavioral mistakes is a big part of our value proposition, but it really, I believe, is or ought to be a big part of the value proposition. of anybody in the financial advisory profession. So I would argue that the fee issue is a little bit skewed here because what we're actually talking about is not fee or no fee. It's fee for advice with active management or fee for advice with passive management.

But it's not fee or no fee. Now, unless the advice consideration is taken out, then you may have someone who is not paying a fee because they're not receiving advice and not in a relationship and not under an advisory umbrella and they're using a passive investment. Well, then now they are not paying a fee. But I still just think it's important to clarify that the S&P 500, as this example of an index fund we're using, is a passive approach. And most advisors that use the S&P 500 are charging their fee for advice. For us, while we use multiple asset classes and have a very distinct philosophy of investing, we believe our fee is a byproduct of a holistic

relationship. And if I woke up tomorrow and said the only investment anyone should ever own is S&P 500, I wouldn't be changing our fees at all. The fact of the matter is that we just happen to have chosen to have a business model that has the same fees, but just a lower margin. to us because I have to spend what it equates to massive amounts of money to run an investment department. We're actively managing the analysts, the research, the trading, the technology, the infrastructure. This is a multi-million dollar investment annually on our part. That was our decision.

Now when I say decision, there isn't really a decision. That's what I believe in. It was never a time where I said, should I or shouldn't I? It was always just going to be because we're going to do what we believe and do. what we believe in doing. But I say that to illustrate something. The margin to the advisor is not really that relevant to an individual investor. What matters to investor is whether or not they are receiving value in that relationship. And part of the value would come from an investment solution that either works or doesn't work for them over time, helping to meet their particular goals

in the criteria that they have. I happen to believe that most investors are different from one another, that there's different psychologies, different emotions, different income objectives, different cash flows, you know, just a whole series of different things that are going to be different, and therefore we believe in a lot of investors having different portfolios in that sense.

But all of that to say, I mean, this is quite a bit of setup, but I think it's important context to make sure we're clear on what we're talking, about what we're not talking about. The notion of S&P being a very low-cost way to access a diversified market, the S&P 500, the large cap space of the United States publicly traded stock market, that's indisputable. But there's not that many investors who only own the S&P 500. it just in narrowly contains more volatility than many investors are comfortable with. And it also lacks exposure to certain asset classes that many investors want.

And then I think that the income issue, too, is a big deal, that at a barely 1% yield, there's a lot of investors that might need more cash flow than they can get out of the S&P. So I don't want to overstate what we're talking about. If there's a whole lot of people that own a lot of other things besides the S&P, then why devote a whole dividend cafe to the S&P? Well, the reality is whether someone owns 100% of their portfolio or 20% of their portfolio or 0%. The fact of the matter is that the growth of S&P 500 ownership, passive index ownership is massive.

And in the late 90s, as I was beginning a career in professional, investment management, there was about $280 billion in all S&P 500 index funds put together. Most of that time were mutual funds. ETFs had started in the earlier 90s, but they weren't really a thing yet. And the kind of famous kicker for the S&P 500, Spy, SPY, it launched in 1993. And by 1999, it had like $20 billion of assets in it. And that seems like a lot of money. It isn't now, but in the grand scheme of total market picture.

But, you know, that SPY now is $675 billion. S&P index funds are now somewhere in the range of $3.7 trillion, okay, in aggregate size. Now, that's including ETF and mutual funds. That does include all sorts of other index funds and other market indices that we could be talking about that certain index funds seek to replicate. I'm just referring to the S&P 500. Now, one thing that you could say is, well, yeah, I mean, it's grown a lot, but the market has gone a lot.

So you would expect the total size of the space to be a lot higher, and that's true. But the market cap of all S&P 500 companies put together 25 years ago was $14 trillion, and it is $57 trillion now. the market's up about four times in nominal terms. The growth of the index market, when I talk about $280 billion going to, what is there, $3.7 trillion, is $14, excuse me, 13 times. Okay, so market appreciation doesn't even come close to covering the explosion of size that we've seen in indexing. Now, there's a number of factors that have pushed ETF ownership so popular. I think a big factor was that many people in the 90s had active managers that were looking to outperform the market

and they were trying to do that by really buying heavily those things that were most popular. That seems like a really great way to not get fired. Buy the things that are going up. Everyone likes that you own these things. Maybe they keep going up even more and voila, big, huge performance. But then when that dot com and tech crash came, it blew up a ton of investors. It blew up a ton of investments. And it certainly blew up a ton of people

that used the term investment advisor or money manager. I would argue the same dynamic played out just about eight years later with the things that had done so well into those mid-2000s with big finance companies, mortgage companies, housing, that space that represents. presented a real bright, spotted markets. Some people loaded up because it was the popular thing, and then it blew up. So I think coming out of the financial crisis, you had a lot of people that were tired of betting on these big things and then having a blow up, and the index became a way to, yes, it took outperformance off the table, but it also took underperformance off the table.

And I would argue that at this time, the ease of ownership, the access, the lique, liquidity, the market functionality, American capital markets, which I sing the praises of as often as I can, had just through never-ending innovations, created something far more efficient, tradable, accessible, better way to get index replication all at a lower cost than we had ever seen. And so, yeah, it became more popular after that. But then I think you can't really leave it just at the mechanics and the won't get burned again sensation after dot com and financial crisis. I think you also have to look to what happened in markets post financial crisis. You can call it ZERC, the zero interest rate policy where the Fed held rates at zero for 14 years.

Call it QE where the Fed added $4 trillion to their balance. sheet and another $5 trillion after COVID and essentially floated significant liquidity into our financial markets via bank reserves. You could call it financial repression, which is where real rates were negative for basically most of the last 17 years. Essentially, net of inflation, the interest rate on just holding money, T bills, CDs, money market funds, was below 0%. This incentivized people holding money

in risk-free assets and incentivized people to push out on the risk curve. You could definitely call it earnings recovery. I think this is probably the most important part of this whole post-crisis story. At the bare market of that brutal recession, we got down to $50 a share of earnings in the S&P 500,

and right now they're somewhere around $270. So you had real earnings growth, financial repression. We had an economic period of basically going 16 years without a recession, the COVID anomaly notwithstanding. And so all of these things put together, call it whatever you want, but you had an unprecedented period of earnings growth, multiple expansion, market performance that was captured in index ownership with, by the way, lower than average volatility.

So there shouldn't be a big surprise with all of these structural and market economic forces combining together why index popularity is grown the way it has. But there are some changes and they're not just in the fact that the index is now 13 times larger than it was. Index ownership, the size of the space is 13 times larger than it was. was. What people own in the index has categorically changed. Now, the SMP 500 is still the S&P 500 and some companies go and some companies come out. And that's always been the case. But the makeup of the index, and I know I've talked about this a ton, but it's my job because I think

this is a big deal. Ten companies make up 40% of the S&P 500. When you look at Nvidia right now is seven and a half percent of the S&P 500, one out of 500 companies. So we can do this math inversely. 490 companies are 60 percent and 10 companies are 40 percent. And both Apple and Microsoft are near about six and a half percent each. This is double the weighting that the top 10 companies represented 20 years ago. In 2005, the 10 biggest companies represented about 20% of the index. They now represent 40. 1985,

the top 10 companies represented a little over 10%. So it has quadrupled since I was 11 years old watching Alex P. Keaton on family ties. In 40 years, the market's top 10 companies have gone from 10% of the S&P to 40% of the S&P. And I think it's perfectly legitimate to say that's a feature, not a bug,

to make an argument that having 10 companies be 40% is what you want. It's certainly been a good thing for market performance the last almost three years now since the end of 2022. You could also very legitimately argue it's a bug, not a feature, that it is intensified risk. It's created not only different concentration, but different valuation. risk in markets that the S&P is trading at over 23 times earnings. And if you if you just brought those 10 companies down to 20% instead of 40%, that alone would bring the market multiple to below 20. So you're getting a valuation intensity and a concentration intensity and that is a different

risk profile. You can look at it either way as a feature or a bug. I am just here to say you can't look at it as if it's the same thing. Something is very different. And what that difference is you may like or not like, or as is probably the case of most investors like it until you don't like it. But what I am trying to say is you have to understand that it's different and that investors have a right to know that difference. Now, there are some that say that this heavy index ownership is driving the value of these companies. And I think there's some misnomerous here that have to be clarified. On one hand, I'm certainly happy to say yes, that the indexes are driving these 10 names higher. They have a built-in bid, that there's daily flows that are coming in as a

result of people buying the index, and that's helping sustain these big companies. And that those big names are helping drive the index higher. There's a circularity in that that I would answer yes, too, okay? But the volume being bought in the indices is proportionate to the market cap of those companies. And that valuation, that market cap, the valuation is not set by the weighting. The waiting is set by the valuation. This is where the chicken or egg is very easy to clear up. And if it wasn't, then why does it change a bit? Why were companies that were number six, now number one and companies that weren't in the top 10 are now in the top 10 and a company that's number, you know, these things are moving around because there's still individuality.

Now, the individual valuations being put on these companies might be insane. It might be great and it might be great until it's insane. And by the way, I think you already know what I think about that. But my point is I'm defending the fact that these companies have their own valuations for a combination of earnings and sentiment being put on those. earnings individually. And then some of that is what means to the weightings within the market. And so to say that the index is creating the valuation is to, I think, misunderstand. There's definitely a feedback loop in it, but the chicken or egg needs to be understood. And again,

you have to realize the consistency here. I mean, if people believe volume sets price, which it does not, okay? And I guess a better way to put it is it ultimately does not. But if one believed it, you have to believe that in good and bad markets. And therefore, whatever exacerbation effect you're talking about that the heavy index buying would be exacerbating in certain times, it would just simply go the other way in a bear market. It's a kind of reciprocity. It would cut both ways. But it misses the point that the value set on a given company is ultimately a byproduct of the company's earnings and the market sentiment around those company's earnings. An index volume has to match that price, but it doesn't set to that price. And if it did,

then we wouldn't see changes atop the leaderboard. Now, when we get past this wondering if indexes are just permanently giving us a great bid on pricing and move to a more reasonable question about systemic risk. There are those, and I had to read in my preparation for this week's Dividy Cafe, three different academic papers this week at different points of argument about where index ownership is impacting systemic conditions in the market. And I'm perfectly comfortable accepting that index trading has pushed correlations among stocks higher.

It's called convergence of beta, and I think that the correlation individual stocks have to the overall market has gone higher. But there's ample evidence that is not true when it is not true. And what I mean by that is that there are periods where the correlations drop, that idiosyncratic conditions take over. We've had a period of 13 times increase in index ownership, but plenty of periods along the way that bucked the trend of correlations. I don't think anything can be said to be true when it's only true sometimes.

The fact of matter is that passive indices owned 30% of the market, okay? That means that 70% of U.S. equity ownership is outside of passive indexes. But more importantly, when you talk about the kind of correlations and daily activities and so forth, buy-cell volume on a day-to-day basis is only about 5%. It can get as high as 10% soaking wet from index activity. So price discovery is still overwhelmingly dominated by non-index actors, traders, arbitrages, active managers, hedge funds, a wide variety of market actors. And so correlations have always been very high during bad markets,

but there are still ample moments of idiosyncratic risk reward. And I think that to look at this historically is to understand that there's nothing new under the sun about market correlation. The more compelling issue when people bring up systemic risk, I want to make an argument is not a systemic risk in my mind at all. And that is that we don't know if we had a significant sell-off, and you look back to some of the days of real big panic selling, would indexes be to have orderly fills of trying to maintain that index replication?

Now, that's a much more legitimate question when there's levered strategies. There's all sorts of market activity that could run into disorderly activity. We've seen some of it outside of just regular SMB 500 index funds, other asset classes during periods of market dislocation. And so I'm perfectly open to the idea that there are environments and there are circumstances that could create some sort of structural dislocation. I have a very hard time calling that a systemic risk. That's because we're investors. And in a period of big market dislocation and someone says, well, I tried to get in the market, and to go sell this and do this and everything was screwed up and orders couldn't get filled.

Why in the world is someone playing on the freeway in the middle of that kind of situation? You might want to consider not playing on the freeway ever. You are not, you're not an investor if you're talking about I'm trying to do orderly trading in a disorderly period. That's not a systemic risk to someone who holds long-term assets that are matched to long-term investment objectives. Now, I certainly understand there's plenty of market actors that are not that. But I am. My clients are. So to the extent that someone says, I can see a scenario where trading gets hard, well, I've seen those scenarios my whole career. And then I went to work the

next day or the day after. There are dislocations that exist, and they're far more prone to happen in different asset classes than large cap equity. But no, I don't believe that there is a systemic risk from increased equity ownership, meaning market functionality that could affect us non-index owners. What I believe is a risk to understand an index ownership is that the index is trading in 23 times earnings. Do I think that is expensive? Yes, I do. And do I believe that when forward returns are to be analyzed from a purchase point of elevated valuation, that we expect a lower return environment. I do.

And the inverse of that means when you are purchasing at a higher valuation, you expect a lower return environment. These things are inverses of one another. I believe all that. So there's valuation and concentration risks in holding the index. I respect it, recognize it, but that's not the way that systemic risk is being referred to here in terms of market functionality. I want to be able to separate liquidity risk, operational risk, from the risk that we care about as a fiduciary investment advisor, which is outcome-based risk. Do I believe that the way we're managing money for clients is going to represent a valid, cohesive, coherent tool to meet

those objectives. Look, in conclusion, I understand that index funds have exploded in popularity over the last 25 years. There's some good reasons for that and there's some less good reasons. At the end of the day, I am less concerned about the dynamics of index ownership because we don't own them when I refer to those dynamics as being valuation and concentration differences. They are dramatically different. The dividend yield is dramatically different. not as much in the last 20, 25 years, but over 40, 50, 60, 70 years. It used to be market investors were getting a much higher dividend if they owned the whole market. But it's one of the big reasons why we don't believe dividend growth can be done passively,

that there is a need if you're both managing for higher yield, but also growth of income that will be sustainable. It does require an active approach. but technical vulnerabilities in markets for a day or two or trading dislocations, those things are just simply outside of what I would be concerned about. They are noise, and noise comes and goes, as do all investment fads. I believe, we believe at the Bonson Group that while noise comes and goes, cash flow is forever, so that's how we invest. But in the meantime, in a day and age of index ownership,

I would recommend for those that are heavily invested indices to just make sure they know what they own and make sure they're getting the advice they need in their advisory relationship. And as it pertains to the way we do things at Bonson Group, we are very appreciative for heavy market liquidity, heavy efficiency in markets, for all sorts of capital market innovations, but we want to do a very distinct thing, a very, yes, active and bespoke thing on behalf of our clients that matches our philosophy. And to that end, we'll continue to work. I hope this is all made sense. Reach out any time with any questions. And certainly, if you're listening to this and interested in getting a kind of second opinion on what it is you own,

whether it's indexes or other forms of investments, we're happy to provide that second look anytime. The last thing you're going to get is any kind of pressurey deal with us. We're just happy to be a set of Eisenhower's for you. We're cool like that. All right. I'm going to leave it there.

Have a wonderful weekend. I'll be heading back to California this weekend where I will be working in our Newport Beach office next week. And in the meantime, want to wish all of you a great weekend. Thank you for reading Divany Cafe. Thank you for watching it. Thank you for listening to this podcast. Have a wonderful weekend. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy ourselves securities.

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