Investors who have invested over the past year in a portfolio of shares that passively replicates the S&P 500 index or JSE all share index (Alsi) have every reason to be pleased. The value of their US portfolio, with dividends reinvested in the S&P 500, will have grown by 27% over the past 12 months. In the year to date ― despite the Middle East war and significantly higher US bond yields ― the index has returned nearly 11%, gaining further momentum after the war began. US 10-year treasury bonds yielded 4.17% per annum in early January and now offer 4.5%. Investors replicating the Alsi have gained even more: up 24% in rand and 37% in dollars since May last year. But the war has damaged the JSE, which is down nearly 11% in dollar terms since February. (Dorothy Kgosi) Investors in the S&P 500 and JSE should also be highly cognisant of the risks they run holding shares strictly in proportion to their market value represented in an index. While storming ahead, the S&P 500 has become ever more concentrated and dependent on the performance of a few stocks. The index has become less diversified and thus more exposed to the risk of a drawdown. The top 10 counters by market value now account for 38% of the index, a share that has probably never been higher. In 2019 a different top 10 contributed a mere 16% to the index. The JSE has on average over the years been more concentrated than the S&P 500. Since 2019, the top 10 companies by market value included in the Alsi have accounted for about 50% of the index, and this average has not varied much in recent years. However, it has come to be dominated by resource companies, buoyed by much-improved prices for precious and other metals. Of the 49% share of the Alsi accounted for by the top 10, resource companies account for nearly 20%, with gold mining companies AngloGold and GoldFields together making up 13% of the index. Clearly such concentration is a risk that the average risk-averse active fund manager would be reluctant to take. It is not safety first to hold 8% of a portfolio in a chip producer or 13% in two gold mining companies. The JSE provides at least one conspicuous example of how blind index tracking can hurt. After an extraordinary run ― a 10-bagger and more ― Naspers came to dominate the Alsi with its extraordinary growth in market value. In 2020, Naspers and its associated company, Prosus, accounted for more than 25% of the index. That proportion is now down to 9.6% but is still enough to make Naspers the largest company on the JSE with a near 8% share. However, after peaking at 25% in early 2020 Naspers and Prosus underperformed the index to fall away in relative size on the JSE. Holding 25% of a share portfolio in Naspers and Prosus in 2020 proved to be a really bad idea that risk-conscious active investors had hopefully not subscribed to. It was a danger index trackers could not avoid. Much of the underperformance of Naspers, and more so of Prosus, came in 2021 and 2022. These two counters are now again lagging well behind the index. Undiversified portfolios are risky by nature. Nature demands that higher expected returns come with increased risks of failure. Stocks that come to dominate an index may also be more volatile from day to day than the average stock. Add market risk, and one-time market leaders can become laggards that will drag down the value of an index-tracking portfolio. Financial history warns us that passive index tracking is clearly not without risks. It all depends on the indices being tracked: the less diversified they are or become, the more risky they are. Some indices will be more concentrated than others. The Korean Kospi ― also now running strongly ― is dominated by just two chip producers. Nokia used to account for 90% of the Helsinki index. At one point, when the gold price took off in the 1970s, gold mining companies accounted for 60% of the JSE. Active investing is not only about realising market-beating returns. It is as much about managing the risks of the ultimate shareholder in a sensible way. But the risk-averse investor would almost inevitably underperform the indices when they are running hard, led by a few counters, as has been the case recently in New York and Johannesburg, whether it is Nvidia on the S&P or GoldFields on the JSE that is driving the index higher. When the race has been run and the outcomes are known, future conscious risks ― the before-race odds ― become irrelevant. Too few appreciate risk-avoidance strategies when the risks, with good luck or perhaps judgment, have proved to be overestimated. It takes a market drawdown to appreciate risk avoidance and appropriate diversification strategies. That’s not something to be wished for but to be planned for. • Kantor is head of the research institute at Investec Wealth & Investment, and Evans head of portfolio analytics at Investec Investment Management. They write in their personal capacities.