How index-fund investing turned into an extreme sport

Mint

2 days ago

Peter Lynch, the former portfolio manager of Fidelity Magellan Fund, has long warned investors against what he calls diworsification: cluttering a portfolio with too many investments.
I think many investors should worry instead about deversification.
That's the opposite of diversification. Rather than spreading your bets, you concentrate them—and that can be dangerous.
Deversification is sweeping through the world of exchange-traded funds. Investing in an ETF that tracks only a few stocks—or even just one—is a lot more exciting than holding an index fund that owns every stock in the market.
It's also a lot riskier.
Back in 1998, according to Daniel Sotiroff, a senior analyst at Morningstar, 85% of stock-index funds were weighted by capitalization. The biggest stocks had the heaviest representation, as in the S&P 500. By the end of 2024, only 40% of index funds were capitalization weighted.
The median, or typical, index fund held 503 stocks in 1998, Sotiroff found. By May 2025, that had shrunk to 123 stocks.
The more recently an ETF launched, the fewer stocks it tends to own. 'A lot of newer investments are taking on more risk than investors may realize," Sotiroff says.
The irony is that many people worry about how concentrated the S&P 500 is in only a handful of huge tech companies. They then turn around and concentrate their own portfolios in an even riskier handful of stocks.
Let's be clear: Bundling a limited number of stocks inside an ETF doesn't make them safe.
The fewer stocks you hold, and the farther away from the overall market you move, the more extreme your returns are likely to become. Your potential gains are greater, but so are your losses.
Between 1985 and 2024, the average stock suffered a maximum interim decline of 81%, and more than half never regained their previous highs, according to analysts Michael Mauboussin and Dan Callahan of Morgan Stanley.
What's driving the wave of deversification?
Fund managers want to earn higher fees than the pittance they can make running an S&P 500 or total stock-market index fund. And many investors are chasing higher returns—and more excitement than they can get from a traditional index fund—by focusing their bets and taking bigger risks.
We now have ETFs that capture the returns of heating, ventilation and air-conditioning stocks; own convertible bonds issued by companies that hold bitcoin in their corporate treasury; use borrowed money to buy already leveraged loans; follow an index of small-to-midsize uranium stocks; track the future cost of transporting crude oil by sea; and replicate the performance of Icelandic stocks. Although some are actively managed, many charge fees 20 to 30 times higher than a traditional index fund.
The ultimate in deversification is leveraged single-stock ETFs. They typically seek to double or triple the daily performance of only one stock. (A few aim to amplify the opposite of its return each day.)
When these funds rolled out in 2022, they jacked up the returns of giants such as Apple, Microsoft or Tesla.
'Now we have gone far, far down the capitalization scale," says Todd Sohn, an analyst at Strategas Securities, 'toward much more volatile names."
ETFs launched in the past couple months seek to double the daily returns of such tiny, hyper-risky stocks as electric-aircraft maker Archer Aviation, computing provider D-Wave Quantum, nuclear-power developer Oklo, voice-recognition company SoundHound AI and lending platform Upstart Holdings.
In their brief lives, these funds have generated cumulative returns ranging from a 26% loss to a 226% gain.
As of this month, more than 100 leveraged single-stock ETFs manage a total of more than $23 billion.
So far, those funds constitute only about 0.2% of total ETF assets, according to Sohn. But their average daily trading volume has more than doubled in the past year, to nearly $9 billion.
They aren't the only deversification danger. ETFs that don't use leverage and are linked to narrow market segments rather than a single stock are risky, too.
ETFs tracking indexes of cannabis stocks lost more than 90% between 2019 and 2023. ETFs following solar-stock indexes have fallen more than 70% at least three times. Index funds that use such factors as equal weighting (tilting toward smaller stocks) or momentum (rapid price appreciation) have suffered deeper drops than the overall market.
Nevertheless, money keeps pouring into quirkier index funds. Last year, $132 billion went into non-market-capitalization-weighted index funds, according to Morningstar. Another $25 billion flowed in during the first five months of 2025.
When you buy a narrowly focused ETF, you're making an active bet on the direction of a particular market or asset. You've become deversified.
And that can easily turn into speculation. Unlike many other pleasures, speculation isn't illegal, immoral or even fattening. Speculating on stocks also beats the lottery or casino, where your odds are even worse. It can be educational, engaging and just plain fun—for as long as the profits last.
But it's putting you at risk. In fact, the more fun speculation feels, the more likely the profits are about to fizzle.
If you must speculate, bear a few things in mind.
First, amplifying the risk of single stocks can make you a ton of money when the market is going up. It will wipe you out when the market goes down.
Limit your bets to a maximum of, say, 5% of your total assets. That way, you'll make a lot if you bet right but can't wreck your financial future if you turn out to be wrong.
Finally, don't fall for the delusion that an ETF owning some but not all of the market is diversified. It's deversified.