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The S&P 500 index is one of the world’s best-known stock benchmarks. Composed of the 500 largest publicly traded US companies, it is the foundation of institutional and retail portfolios. It even got the nod from Warren Buffett, who once said, “In my opinion, the best thing for most people to do is to own an S&P 500 index fund.”
Buffett’s proposal for the S&P 500 gave 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 realize that the index is at a record high level of concentration. This concentration poses significant risks because the performance of the index is heavily dependent on the fortunes 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 the benefits of diversification and makes portfolios extremely vulnerable to sector-specific downturns or company-specific problems.
Over the past two years, a heavy weighting in technology and large-cap growth stocks has proven successful for investors. Fortunately, there are some inexpensive ways to take some chips off the table and switch exposure to other low-cost, more diversified indexes.
Stay in the S&P 500 but move to equal weight
One way to add diversification to a typical exposure to the market-cap-weighted S&P 500 is to stay in the same companies but use an equal-weight approach. This strategy, which can be deployed with an ETF such as RSP, Invesco S&P 500 Equal Weight ETF, provides equal exposure to all 500 companies in the index. This approach ensures that no company will disproportionately affect the performance of the index. The top 10 stocks make up only 2.8% of the portfolio.
The peer index also has a lower price-to-earnings ratio (19x) than the market-cap-weighted index (22.5x) because it has less exposure to trillions of dollars, high growth and a high P/E. technology stocks that dominate the S&P 500. In other words, investors who fear the rising valuations of giant tech firms can reduce the risk of a correction in P/E multiples in the event of a recession or other event.
Microsoft, Nvidia and Apple have a market capitalization of more than $3 trillion, which together make up more than 20% of the index. To put concentration risk in context, the 50th largest company in the S&P 500 is currently Philip Morris with a weighting of 0.36%. Philip Morris would have to rise or fall by about 20% to have the same impact on the index as a 1% move in Microsoft, which has a 7% weighting.
While adding diversification, ETFs of equal weights have some risk. They tend to have higher 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 outperformed most markets
Add extra exposure with a small cap
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 provide 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 holds 2,000 domestic shares; the top 10 companies have a combined weight of 5.6% of the portfolio.
Small-cap stocks have underperformed large-cap stocks over the past few years. For example, the IWM is still 17% below its 2021 high, while the S&P 500 is making new highs. If small-cap stocks return to favor, the gap in past performance could narrow.
One reason for the recent underperformance of smaller companies relative to large-cap stocks in the S&P 500 is interest rate sensitivity. Small-cap companies typically have higher leverage and lower debt-service coverage ratios, so the rise in interest rates over the past two years has disproportionately negatively impacted stocks in the small-cap space. Now that inflation is falling, a corresponding drop in interest rates could be the catalyst that begins to close the performance gap between the IWM and the S&P 500.
Small-cap stocks are generally more volatile and can experience more significant price swings, especially during economic downturns. As mentioned above, they are also quite sensitive to changes in interest rates, so a pick-up in inflation and subsequent shift in yields could dampen performance. However, small caps are currently at their cheapest level in years compared to large caps, making them an attractive diversification alternative.
Include an allocation to international stocks
When it comes to diversification, many investors are underweight international stocks in their portfolios. International ETFs provide exposure to non-US companies, offer geographic diversification and reduce dependence on the US market. Investing in international stocks can also provide currency diversification, which can be beneficial in times of a weakening US dollar.
An easy and inexpensive way to gain exposure to international stocks is through the Vanguard All-World Ex-US ETF, VXUS. It owns over 8,600 stocks of all sizes in developed and emerging markets. The top 10 stocks make up 11.4% of the ETF. VXUS essentially 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 some of the reasons for the underperformance. From a valuation perspective, international stocks are comparatively cheap. VXUS’s P/E ratio is 14.9, a multi-decade low compared to the S&P 500.
International investments are subject to political, economic and regulatory risks that may not be present in the US market. Also, fluctuations in exchange rates can affect the returns of international ETFs and add additional volatility. Even with some incremental risks, the benefits of diversification by 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 stellar. 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. It also drove the S&P 500 to record high levels of concentration.
Increasing concentration in the S&P 500 represents significant risk for investors seeking diversification. Investors can reduce risk and improve the diversification of their portfolios by considering alternatives such as S&P 500 equal-weight ETFs, small-cap ETFs and diversified international large-cap ETFs. Even Warren Buffett might agree.