S&P 500: Busting the diversification myth

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.