Matterhorn Disaster by Doré

You are in a buy-and-hold, passive investment. So, you will make market returns.Not quite: With the markets, doing nothing doesn't mean you're not doing something. Because while you are sitting on your hands, things are happening around you, and your investment portfolio is changing. The reason is that you are in an index that is market capitalization weighted. The bigger the company, the more of it you are holding. This means you are going to hold more in industries and sectors that by nature have big companies. So more in big banks and insurance companies than in specialty retailers and restaurant chains. And, more important for the point I am focused on in this post, increasingly more in companies that are doing well, that is, companies that have rising market capitalization. And on the flip side, you are effectively selling off stocks that are not doing so well.If Apple is worth five times as much as XYZ, then you hold five times as much in Apple as in XYZ. And if Apple moves up to be worth ten times as much, you hold ten times as much. This is what will happen with what appears to be a buy-and-hold, passive, do nothing portfolio.This is a big concern now because of the run-up in the FAANG (Facebook, Apple, Amazon, Netflix, Google) and related stocks. They have taken a large share of market capitalization as they have risen in value, and there is a momentum dynamic to be unleashed if they start to drop. This has happened time and again when cap weighting has led to extremes in the share of total market capitalization claimed by a popular sector. Consumer discretionary grew to 22% of the index in 1972; Oil 30% in 1980; TMT 34% in 2000; Banking 23% in 2007. In each case it finally got out of hand and dropped back to its earlier level and dropped the market as well. The odds are it will happen with FAANG.Of course, the market cap does not rise by magic. Each time investors find a reason for the sector to be gobbling up the market. With TMT it was that the old methods like P/E were no longer relevant. So I don't get much comfort in the justifications for the domination this time around of the FAANG and related stock.This is bad, for both you and for the market generally. First off, you get more and more concentrated. Which means less and less diversified. Secondly, it is bad for the markets because you might be doing nothing, but the effect is to pile on. If someone comes into the market, they are really stocking up on Apple, so, guess what. Apple really goes up.What is particularly problematic is that when you are in cap weighted passive, you have a factor bet without realizing it. Because you are following a cap-weighted index, because you are measuring yourself against that index, the factor bet looks like "no harm done." It looks like you are simply moving with the market, the end objective of a passive position.An alternative that has taken hold is to hold stocks based on some other factor than market cap. The problem is that any rule that is based on some factor is going to have the problem that you are still making a bet. What you want to hold is a portfolio where you can pick any factor -- P/E, capitalization, momentum, any "smart beta" factor of your choosing -- and fail to find any relationship between that and your portfolio return.