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Advisors often lean broad market stock funds as the foundations of the equity sleeves of client portfolios. From there, advisors can get more tactical with dividend, industry and sector strategies, among others, but broad market funds are usually the cornerstones of equity portfolios.
One of the reasons for that is “broad” implies “diversification.” In recent years, the diversification benefits offered by funds tracking indexes such as the S&P 500 have waned in dramatic fashion. Consider the case of the SPDR S&P 500 ETF Trust, also known as “SPY,” and other S&P 500-tracking index funds and exchange traded funds. As of June 6, just three stocks – Microsoft (NASDAQ: MSFT), Nvidia (NASDAQ: NVDA) and Apple (NASDAQ: AAPL) – combined for almost 21% of SPY’s roster.
That trio has combined market caps of $15 trillion. Putting $15 trillion into context, it’s about the size of the combined market values of the companies trading in Shanghai, Shenzhen and India’s stock market.
Going even further on the S&P 500’s concentration levels, the top 10 holdings now combine for about 35% of the index’s weight. Of that number, seven, and more recently five, have done much of the heavy lifting. However, those elevated levels of concentration haven’t diminished performance as highlighted SPY’s 32.2% return over the past three years. There are other reasons why investors shouldn’t be alarmed by a small number of stocks commanding large weights in marquee benchmarks.
Bringing Context to Concentration Risk
In a recent research paper about concentration and its implications, Michael Mauboussin and Dan Callahan showed that from 1950 through 2023, the stock that ranked largest in the S&P 500 often lagged the index. However, Apple changed the complexion of that fact over the past decade.
“Apple has been the largest stock in the S&P 500 for 99.96% of the time since 2014. And over that time, it’s up 861%, almost four times better than the S&P 500. That’s 25.4% compounded annually for the last decade, compared with 12.6% for the S&P over the same time,” notes Michael Batnick of the Irrelevant Investor.
Obviously, Apple’s mostly undaunted rise over that period helped the S&P 500, prompting the question “Is concentration really so bad?” As Batnick points out, it’s a negative for active managers that attempt to beat highly concentrated indexes. Many of those managers run funds that have caps on weights assigned to individual stocks. That’s not an issue with most index funds.
Then there’s the point that selling investors on diversification, i.e. owning a bunch of stocks under one umbrella, is difficult when they’re inundated with headlines about just a handful of names leading the market higher. It’s likely that most ordinary investors are willing to sacrifice diversification in the name of higher returns and that makes sense.
Concentration Conundrum Not Really a Conundrum
Speaking of returns, rising levels of concentration aren’t a headwind. Actually, history suggests that scenario is a tailwind.
“It turns out that the stock market does better during periods of rising concentration,” adds Batnick.
Bottom line: in theory, index diversification sounds nice and concentration risk sounds negative, but the reality is everyday investors and clients clearly don’t need to fret about rising levels of concentration. They’re actually being rewarded by it.
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