S&P 500: Busting the diversification myth S&P 500: Busting the diversification myth S&P 500: Busting the diversification myth

S&P 500: Busting the diversification myth

Equities 4 minutes to read
Charu Chanana

Market Strategist

Summary:  A string of strong gains recently in technology stocks have increased their concentration in the S&P 500 index which is market-cap weighted. This has evaded the diversification benefits of investing in an index such as the S&P 500, given it has become over-exposed to higher interest rates. An active strategy to diversify across asset classes, industries and geographies has therefore become even more important.

Often times, investors pick index funds for a diversified exposure. To be fair, this strategy has its merits over investing in a small number of stocks. However, secular changes recently have led to a concentration in the type of stocks that some of these indices represent.

S&P 500 is one such example of an index that has recently become too heavily weighted towards large cap, growth companies. This means the index is now over-exposed to interest rates and provides very little true diversification.

This is important to consider because of several factors, such as below.

Index concentration can obscure underlying market trends

Gains driven by the recent increase in interest in the artificial intelligence theme brought significant gains to mega cap technology companies. Today, top 10 companies in the S&P 500 account for about 35% of the index compared to 25% during the dot-com bubble. This may not be such a big problem if the top companies have little correlations, but 8 of the top 10 companies are technology stocks, and therefore highly correlated and exposed to interest rate fluctuations.

Now consider if US interest rates continue to stay elevated. This means the technology and other growth stocks could be vulnerable. A high concentration of such stocks in the S&P 500 also makes it highly vulnerable to an inflation or interest rate shock, as compared to a “true” diversified portfolio.

What happens when the bubble bursts?

The outperformance of these top equity holdings has been driven by the recent AI wave. That has led to expanding valuations for key stocks such as Nvidia, Microsoft, Alphabet and others. The top five companies in the SPY ETF which tracks S&P 500 – Apple, Microsoft, Amazon, Nvidia and Alphabet – are now trading at forward P/E of 45x, which has stretched the overall index valuation to 20x as well. That makes these gains look fragile, as they are not underpinned by structural or earnings growth.

If investors were to start getting cautious about an earnings or economic recession, that could mean that some of these stretched valuations may start to come off as elevated stock prices get harder to justify. If the AI expectations prove to be a hype or a bubble, then these valuations can unwind as fast as they rallied, if not more.

What is “true” diversification?

In the truest sense, diversification in portfolios is achieved by spreading investments across different asset classes, industries, and geographic regions. A pure equity index exposure never provided diversification across asset classes, and would rarely provide diversification across geographies. However, one would expect diversification across industries by investing in S&P 500, which is not the case now.

Some of the options investors could consider would be the S&P 500 equal weighted (EW) index, comprises the same 500 largest US-listed companies as the S&P 500 which is market-cap weighted (MW), however, each constituent is rebalanced to a portfolio weight of 0.2% on a quarterly basis. The EW outperforms the MW S&P 500 in periods when concentration was high and subsiding, but underperforms when concentration is low and rising.

An active strategy may be even more suitable to address concentration risks. This would mean diversifying large cap exposure by adding some small cap stocks or index, and diversifying growth exposure by adding value or cyclical stocks. However, given risks of an economic slowdown, one will need to be selective about cyclical or small cap stocks. Lastly, geographic rebalancing across Europe, Japan and emerging markets could bring medium-term tailwinds given cheap valuations relative to the US.


Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000

Contact Saxo

Select region


The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.