Potential Headaches for Traditional Cap-Weighted Index ETF Investors

Index ETFs have been a popular play this year, with the ETF industry attracting another year of record inflows, but as investors jump on the ongoing bull market rally, traditional market cap-weighted index funds may pose risks that many may have overlooked.

U.S-listed ETFs have attracted a record $473.9 billion in net inflows this year, according to XTF data. S&P 500 Index-related ETF are among 2017’s most popular ETF plays. Year-to-date, the SPDR S&P 500 ETF (NYSEARCA: SPY) saw $12.1 billion in net inflows, iShares Core S&P 500 ETF (NYSEARCA: IVV) attracted $30.2 billion in new inflows and Vanguard 500 Index (NYSEARCA: VOO) added $14.6 billion.

The inflows come in as U.S. equities extend their bull market run to their ninth year, with technology stocks like Apple (NasdaqGS: AAPL) and Facebook (NasdaqGS: FB), among others, leading the charge in a growth-fueled market rally. Year-to-date, the S&P 500 increased 21.9% while the S&P 500 Information Technology Index jumped 37.6%.

However, this ongoing surge in U.S. technology stocks may leave traditional market cap-weighted index funds, like the S&P 500-related ETFs, exposed to risks due to their increasingly larger tilt toward the information technology segment. According to the Wall Street Journal, tech stocks made up 19.7% in the widely followed S&P 500 benchmark, and over the past 10 years, the weighting of the tech sector in the S&P 500 at year-end averaged 19.6%. However, information technology companies now make up around 24% of the S&P 500-related ETFs.

“It’s sort of an inherent flaw of index funds,” Kyle Moore, founder of Quarry Hill Advisors, told the WSJ, referring to how outperforming stocks tend to have a bigger share of indices that are market-capitalization weighted, such as the S&P 500.