Examining Concentration Risk in the S&P 500

It’s often said that one of the reasons so many advisors and retail investors flock to broad market index funds and exchange traded funds is that these products are, well, broad. At least they’re intended to be.

However, due in large part to the seemingly indomitable rise of the magnificent seven and a small number of other stocks, there’s increasing talk of concentration risk in funds that, in theory, are supposed to minimize that risk. Using the SPDR S&P 500 ETF Trust as the gauge, we find that the six stocks with market values of $1 trillion or more now combine for 28.03% of the S&P 500 as of Feb. 12. Throw in the other stocks that round out the top 10 in the S&P 500, and the percentage jumps to nearly 33%.

Taking things a step further, 25 stocks – less than 5% of the S&P 500’s membership – command 46% of the index’s weight. Diversified that is not, but it also might not be the cause for concern it’s made out to be. After all and not to be trite, but many clients aren’t going to get wrapped up in index minutia. They will, however, be concerned about performance.

Concentration Risk Points to Ponder

Diversification has often been billed as a cornerstone of well-balanced portfolios, but what’s transpired over the past several years indicates that asset-level diversification, not individual bets within funds, is what could be most helpful to clients.

Regarding the diversification or lack thereof in the S&P 500, the current state of affairs isn’t new. Perhaps to the surprise of many clients, the index has been down this road before.

“Throughout the 1950s and 1960s the top 10 stocks regularly made up around a third of the total market cap of the S&P. Then the Nifty Fifty one-decision stocks took over in the late-1960s/early-1970s and the top 10 holdings jumped to more than 40% of the index,” notes Ben Carlson, author and proprietor of the “Wealth of Common Sense” blog.

Carlson adds that for most of the 1980s, the S&P 500’s top 10 holdings accounted for 20% or less of the basket, but that total would reach 30% just before the tech bubble burst in 2000-01. The points are the S&P 500 has had its bouts with elevated concentration among a small number of holdings and these aren’t tells of bear markets. Even the elevated weights to a small number of equities in 2000 wasn’t the cause of the bubble bursting. Flimsy financials and valuations that had gotten far out of whack were.

U.S. Not Worst Concentration Offender

“He’s guilty, too” isn’t a defense in a court of law and it might not play in financial markets, but the reality is, the levels of concentration in the S&P 500 aren’t all that bad when compared with what’s found in some other major developed markets.

Using the MSCI indexes, which serves as the benchmarks for the corresponding US-listed ETFs, Carlson points out that concentration for the top 10 holdings in Canada, France, Germany, Italy and the U.K. is as follows: 43%, 58%, 58%, 66% and 49%.

That might surprise some clients that know that Germany and France are the Eurozone’s two largest economies, which might imply some level of equity market diversification. Interestingly, of the G7 countries, only the MSCI Japan Index (26%) has a lower allocation to its top 10 holdings than does the S&P 500.

“Concentration is a feature of market cap weighted stock market indexes. It’s perfectly normal,” concludes Carlson.

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