Index funds and ETFs can be risky, so it's important to diversify when you can.
Is your ETF or index fund headed for destruction?
I'm going to let you in on an investing secret.
The 'pros' know this secret but most of us ordinary folks do not.
Unfortunately, it's pretty scary. So, prepare yourself.
Indices 101
When you buy into an index fund or ETF, like one that tracks the S&P/ASX 300 (Index: ^AXKO) (ASX: XKO) or the USA's S&P 500 indices, it's vital you know what you are actually tracking.
For example, Vanguard's Australian Shares Index Fund ETF (ASX: VAS) tracks the ASX 300. The iShares S&P 500 ETF (ASX: IVV) tracks the USA's S&P 500.
But what are the indices?
The way these two indices — and, in turn, the ETF — is calculated could have a serious impact on your wealth.
The way they are calculated is by ranking Australia's top 300 shares (for the ASX 300) and the USA's top 500 (for the S&P 500) by their market capitalisation. The companies with the largest market capitalisation get the most weighting in the index.
What is market capitalisation?
Market capitalisation is a number calculated by multiplying the number of shares by the share price.
That is:
Market capitalisation = share price x number of shares
For example, Commonwealth Bank of Australia (ASX: CBA) shares are priced at $81.21 and the company has 1.72 billion shares. So, its market capitalisation equals $139 billion ($81.21 x 1.72).
That's the value of all of the shares in Commbank.
As Australia's largest company, by market capitalisation, it has the largest weighting in the ASX 300. Therefore, to mirror the index, the ASX 300 ETF will buy the same weighting of shares in Commbank.
But here's the important question:
What happens if more money goes into the ETF?
For example, let's say you have already invested $10,000 and put another $10,000 into the ETF. What does the ETF do?
It goes and buys more Commbank shares.
What happens to the share price?
Anyone that knows the laws of supply and demand will understand that more buyers push up the share price.
So, Commbank's share price goes up. And so does the ETF because it owns shares in Commbank.
But the ETF must buy a little more, just to keep pace with the rising prices.
I hear what you are saying: "$10,000 is hardly going to make a difference".
You're right, it will not make a huge difference.
But now consider that $27 billion was invested in Australian ETFs, according to Morningstar. That's more than twice the amount as in 2004.
According to the Financial Times, more than $US 4 trillion (with a 't') is held in Global ETFs.
Of course, not every ETF is doing the same thing (thank heavens!).
But, using the flow of money from above, what happens when money continues to enter these ETFs and index funds?
The result is:
The biggest companies get bigger.
And bigger.
And bigger.
Eventually, these 'big' companies are getting big simply because they are big.
Nathan Bell from the Sydney-based global investment fund, Peters MacGregor, calls these types of companies "expensive defensives". Implying that most people are attracted to them because they are big and safe. But, they are so expensive that they could be becoming quite risky.
Because what happens when prices start to fall?
The investors in the ETFs and index funds get itchy trigger fingers and start to sell. That pushes down the share prices of these big companies (and their market capitalisation).
The price continues to fall…causing more people to become worried and sell…
It's a vicious cycle.
Foolish Takeaway
It's important to remember that holding one ETF or index fund will NOT fix your investing problems. Of course, markets rise and fall. And I think you should have some exposure to index fund ETFs.
But, please, don't put all of your eggs in one index fund.
