Just how diversified are markets?
People who are passively invested in the S&P 500® may think they are broadly diversified across 500 US companies. But that really is not the case today. For example, the top ten holdings in the S&P 500® now account for close to 40% (38%) of the index¹. This is because the S&P 500® is a market capitalization-weighted index. Therefore, companies with the largest market capitalizations--think high-flying tech companies related to the artificial intelligence boom--have the biggest impact on the index’s performance. That impact translates into the index being at historically high levels.
Concentration risk at historic highs
With AI chip maker Nvidia watching its market capitalization soar to $4 trillion in mid-July--the first public company ever to reach that worth--concentration risk in the S&P 500® does not seem to be waning any time soon. Nvidia’s market cap may be a testament to investors’ strong belief that AI is creating an economic transformation as massive as the Industrial Revolution some 250 years ago. Tech giants Amazon and Alphabet also saw strong gains in mid-July from the AI boom--both moving beyond $2 trillion--while Microsoft and Apple have led the way toward the $3 trillion mark. These five tech firms alone now account for 25% to 30% of the index¹.
Beware of valuation and style risk, too
Besides concentration, there are two more unusual risks in the S&P 500 today: valuation risk and style risk. Regarding valuation, the index is now over 25 times earnings, which is an historically high valuation level, with the historical price-to-earnings ratio range between 15 and 20. Compare that to the MSCI World ex. US Index which is currently around 16 to 17 times earnings.
Analyzing the S&P 500’s style bias also shows the index appears to be a highly concentrated, mega-cap technology growth fund. Of course, this doesn’t mean you shouldn’t invest in US tech firms. It does mean, however, that investors should be analyzing the diversification and risk levels in their overall portfolios to help avoid negative surprises if--and when--a tech correction transpires in the markets.
Top 10 stocks in S&P 500¹
Overall, balancing out passive investment strategies that track indices, such as the S&P 500®, with actively managed strategies that have a history of high active share (looking 80% or more different than its benchmark index) in a portfolio has been a way to better manage concentration risk.
¹ Source: Factset
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