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The S&P 500 is one of the most recognizable stock benchmarks in the world. It consists of 500 of the largest publicly traded U.S. companies and is an important part of institutional and retail portfolios. It has even received the endorsement of Warren Buffett, who once said, “In my opinion, owning the S&P 500 index fund is the best thing for most people to do.”
Buffett’s suggestion of the S&P 500 was made to give the average investor diversified exposure to the stock market. However, the composition of the S&P 500 has changed significantly over the years, and many investors may not be aware that the index is at a record level of concentration. This concentration carries significant risks, as the performance of the index becomes highly dependent on the fate of just a few companies.
The top 10 companies now account for more than 35% of the index’s market capitalization, driven by the dominance of tech giants and the rise of artificial intelligence technologies. This high concentration reduces diversification benefits, making portfolios extremely vulnerable to sector-specific downturns or company-specific problems.
Over the past two years, the heavy weight of technology and large-cap growth stocks has worked out well for investors. Fortunately, there are several low-cost ways to take some chips off the table and shift exposure to other low-cost, more diversified indices.
Stay in the S&P 500, but move to equal weight
One way to add diversification to the typical market cap-weighted exposure to the S&P 500 is to stay in the same companies but use an equal-weight approach. This strategy, which can be deployed using an ETF such as RSP, the Invesco S&P 500 Equal Weight ETF, provides equal exposure to all 500 companies in the index. This approach ensures that no one company has a disproportionate influence on the performance of the index. The top 10 stocks make up only 2.8% of the portfolio.
The equal-weight index also has a lower price-to-earnings ratio (19x) than the market-cap-weighted index (22.5x), because it has less exposure to the fast-growing, high trillion-dollar price-to-earnings ratio. technology stocks that dominate the S&P 500. In other words, investors concerned about the rising valuations of giant tech companies can reduce the risk of a correction in price-to-earnings ratios in the event of a recession or other event.
Microsoft, Nvidia and Apple each have a market capitalization of more than $3 trillion, together accounting for more than 20% of the index. To put concentration risk into context, the 50th largest company in the S&P 500 is currently Philip Morris, with a weight of 0.36%. Philip Morris would have to rise or fall about 20% to have the same impact on the index as a 1% move in Microsoft, which has a 7% weighting.
Although they add diversification, equal-weight ETFs carry some risk. They typically have greater exposure to smaller companies, which can be more volatile than large-cap stocks. They also tend to have higher management fees due to higher trading costs and the need to rebalance every quarter.
The S&P 500 has outperformed most markets
Add more exposure to small caps
Small-cap stocks are companies with a market capitalization of less than $2 billion. These companies often have higher growth potential compared to large-cap stocks and have delivered higher returns over the long term. One of the most liquid ways to gain exposure to small cap companies is through IWM, the iShares Russell 2000 ETF. IWM owns 2,000 domestic shares; the top 10 companies have a combined weight of 5.6% of the portfolio.
The performance of small cap stocks has lagged behind that of large caps in recent years. For example, IWM is still 17% below its 2021 high, while the S&P 500 is hitting new highs. Should small-cap stocks return to favor, the gap in past performance could narrow.
One reason for the recent underperformance of smaller companies relative to the large-cap stocks in the S&P 500 is sensitivity to interest rates. Small caps tend to have higher debt loads and lower debt service coverage ratios, so the rise in interest rates over the past two years has had a disproportionately negative impact on stocks in the small cap universe. With inflation falling, a corresponding drop in interest rates could be the catalyst that begins to close the performance gap between IWM and the S&P 500.
Small-cap stocks tend to be more volatile and can experience greater price swings, especially during economic recessions. As mentioned above, they are also relatively sensitive to changes in interest rates, so a resurgence in inflation and a subsequent shift in yields could dampen performance. Still, small caps are currently at their cheapest levels in years compared to large caps, making them an attractive diversification alternative.
Including an allocation to international equities
When it comes to diversification, many investors are underweight international stocks in their portfolios. International ETFs provide exposure to companies outside the US, providing geographic diversification and reducing dependence on the US market. Investing in international stocks can also provide currency diversification, which can be beneficial during times of US dollar weakness.
An easy, low-cost way to gain exposure to international stocks is through the Vanguard All-World Ex-US ETF, VXUS. It owns more than 8,600 stocks of all sizes in developed and emerging markets. The top 10 stocks account for 11.4% of the ETF. Essentially, VXUS owns the majority of public stocks traded outside the US
Like U.S. small-cap stocks, international stocks have underperformed the S&P 500 in recent years. The strength of the U.S. dollar, lower exposure to growth stocks and slower earnings growth are among the reasons for the underperformance. From a valuation perspective, international equities are relatively cheap. VXUS’s price-to-earnings ratio is 14.9, which is at a multi-decade low versus the S&P 500.
International investments are subject to political, economic and regulatory risks that may not be present in the U.S. market. In addition, fluctuations in exchange rates can impact the returns of international ETFs and create additional volatility. Even with some increasing risks, the diversification benefits of adding international stocks to a portfolio should not be overlooked.
Top 10 exposures for SPY, RSP, IWM and VXUS
The performance of the S&P 500 over the past decade has been outstanding. The concept of American exceptionalism is real. Robust capital markets, technological innovation, labor flexibility and significant fiscal stimulus have contributed to exceptional economic growth and stock market performance. This has also led to record high levels of concentration in the S&P 500.
The increasing concentration in the S&P 500 poses significant risks for investors seeking diversification. Investors can reduce risk and increase the diversification of their portfolios by considering alternatives such as equal-weight S&P 500 ETFs, small-cap ETFs and diversified large-cap international ETFs. Even Warren Buffett might agree.