Do You Think Your S&P 500 Index Fund is Diversified? Think Again!
Just what diversification does an index fund offer?
Last week the S&P 500 came close to touching it’s all-time high again! Many investors have benefited from their ETFs or mutual funds that track this large-cap index. What they may not be aware of is just how top-heavy this bellwether has become and the risks associated with this phenomenon.
Unlike the Dow Jones Industrial Average, which is a price weighted index comprised of the share price of individual companies, the S&P 500 is value-weighted or cap-weighted, meaning its composite is made up of the market capitalization of its members.
Since the share prices of tech juggernauts in the S&P 500, including Amazon, Apple, Facebook, Microsoft, and Google have soared over the last year, their market capitalization has grown. That means their share of the total index has risen relative to other sectors in the index, like healthcare and industrials. This has created a top-heavy scenario recently depicted by the Wall Street Journal:
Why is this a problem?
If those top five tech companies are excluded from the S&P 500 index the remaining 495 other companies’ performances looks, well just, mediocre:
As the chart from the Financial Times indicates, just five tech overachievers have delivered investors most of their rewards.
This concentration goes hand in hand with higher risk associated with the idiosyncratic risk of performance of just a few companies as well. This type of risk is further increased when investors also hold these individual firm positions in their individual brokerage accounts and retirement accounts like IRAs and 401Ks.
Investors are not always cognizant of their individual firm holdings and don’t tally up the total weighting of, say, their Microsoft (MSFT) positions across all of their accounts. They’d have to add up the individual stock exposure and the percentage allocated to MSFT across mutual funds and ETFs in each of their accounts. Only then would they have an idea of how much individual firm risk they have.
Without that knowledge, it’s challenging to understand just how exposed they are to a few firms, leaving them vulnerable to a tech industry correction, political challenge, or downturn.
OK, but what should I do?
Investing in this tech heavy S&P index may well be your intended investment strategy. For more risk tolerant investors, no action may be warranted other than to understand their total holdings of these five market cap rich companies across all of their investment accounts and monitor them.
For investors who are more concerned about diversifying their total portfolio or for those on a shorter glide-path-to-retirement, the recent top-heavy run-up in the S&P 500 may warrant portfolio restructuring.
The bottom-line here is that even with ETFs, which are already more diversified than a smaller basket of individual stocks, a more carefully crafted portfolio may be warranted. With calendar year 2020 closing out fast, the time to do so is now.