Hidden Risks Of Index Funds: What Investors Should Know

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Index funds are often touted as one of the best ways to invest for the long-term and for good reason. They can offer instant diversification at low costs and largely outperform active funds over the long run.

But as a smaller number of companies — called the Magnificent Seven — have come to dominate the stock market and the indexes that track it, some are questioning whether passively managed index funds are truly passive.

Here’s what you need to know about index funds and the hidden risks your portfolio may be exposed to.

How the Magnificent Seven entered the chat

The idea behind passive investing is that it is pointless to try to do better than the market averages over time, so the best course of action is to keep your costs low and broadly diversify your holdings. The invention of index funds made it easy to invest based on market indexes such as the S&P 500.

Rather than try to identify which stocks will do well or poorly, index funds invest solely based on the underlying index that they track. So if a company comprises 3 percent of the S&P 500, that’s how much an S&P 500 index fund will invest in it as well.

Because the S&P 500, and many other stock market indexes, are market-cap weighted, the largest companies make up the largest weights in the index and in the funds that track them. That’s how the Magnificent Seven enters the chat, creating challenges as these seven large companies have vastly outperformed the broader market and grown to account for a large portion of index fund portfolios.

The hidden player in index funds

In recent years, seven stocks have come to dominate the major market indexes due to their strong outperformance. Microsoft (MSFT), the largest company in the S&P 500, has a market cap that is about three times that of the sixth-largest company, Broadcom (AVGO).

As the stocks of the largest companies in the S&P 500 have seen mixed performance this year, with some rebounding after declines early in the year, the Magnificent Seven continue to account for even more of the index. These seven stocks make up about 34 percent of the S&P 500 as of June 2025, up from 20 percent in 2023.

Investors in S&P 500 index funds may not be getting what they’re looking for in a fund, says Nick Ryder, chief investment officer at Philadelphia-area wealth manager Kathmere Capital Management. These investors are typically looking for broad diversification and contribution from many different stocks, but instead they’re inherently making a bet on these seven companies, he says.

The impact on the Nasdaq 100 Index was so pronounced that a special rebalancing of the index took place in July 2023 to avoid violating diversification rules for the funds that track the index. The seven tech giants accounted for more than 60 percent of the index before the rebalancing took place.

Ryder says that enthusiasm around artificial intelligence is partially responsible for the outperformance of the largest stocks, while adding that investing based on narratives can be dangerous for investors.

“The problem with narratives is that they tend to be fully reflected in stock prices,” Ryder says.

Index fund alternatives

Investors looking to limit their exposure to the Magnificent Seven stocks, while still taking an index-based approach, have a few options.

• Buy an equal-weighted fund: The first alternative would be to buy an equal-weighted S&P 500 index fund. As the name implies, an equal-weighted fund holds stocks in equal weights, regardless of their underlying market caps. So a $1 trillion company is held in the same proportion as a $50 billion company. You’ll still have exposure to the seven largest companies, but it will be dramatically lower than a standard S&P 500 index fund.
• Buy a value-based fund: Another choice would be to buy value-based funds, such as funds that invest based on metrics like the price-to-earnings ratio. These funds invest in stocks that appear cheap based on quantitative metrics. The Magnificent Seven stocks largely come with premium valuations, so value funds may hold them in reduced weights or not at all.

In Kathmere client portfolios, Ryder says they’re trying to mitigate the impact of the seven largest companies by making thoughtful adjustments to the S&P 500, while acknowledging it’s difficult to outperform a market-cap weighted index over the long-term.

“We’re just taking the overall S&P 500 and tilting toward things that are cheap on fundamentals, and away from things that are expensive based on fundamentals,” Ryder said. “It’s not an either-or decision, it’s about trying to balance the risks.”

Index fund FAQs

• Are index funds really risky?
  

  Index funds are generally not as risky as if you held shares in just one stock. Index funds have broad diversification across many industries and companies, despite the high concentration in tech stocks. However, index funds still carry risk because their value fluctuates based on what’s going on in the market.

• Can index funds go broke?
  

  An index fund going broke — as in failing and running out of money — is technically possible, but extremely unlikely as dozens to hundreds of companies would have to fail to make that happen. That said, index funds can see dramatic declines in value during market downturns, like that of 2008.

• What does Warren Buffett think of index funds?
  

  Warren Buffett is generally a fan of index funds as a low-cost way to build long-term wealth for the average investor, especially index funds that track the S&P 500. Buying a low-cost index fund and holding onto it for a long time can allow you to take advantage of the market’s growth over time.

— Bankrate’s Logan Jacoby contributed to an update.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.