The S&P 500 is one of the world's most recognizable equity benchmarks. It is comprised of 500 of the largest publicly traded U.S. companies and is a staple in institutional and retail portfolios. It has even received the nod of approval from Warren Buffett, who once said, "In my view, for most people, the best thing to do is own the S&P 500 index fund."
Buffett mad his S&P 500 suggestion to give average investors diversified exposure to the equity market. However, the S&P 500’s composition has changed significantly over the years, and many investors might not be aware that the index is at a record-high level of concentration. This concentration poses significant risks as the index's performance becomes heavily dependent on the fortunes of only a few companies.
The top S&P 500 10 companies now account for over 35% of the index's market cap, driven by the dominance of tech giants and the rise of artificial intelligence technologies. This high concentration reduces diversification benefits, making portfolios extremely vulnerable to sector-specific downturns or company-specific issues.
For the last two years, the heavy weight of technology and large-cap growth stocks has worked out well for investors. Fortunately, there are several low-cost ways to switch exposure to other low-cost, more diversified indices.
Stay In The S&P 500 But Move To Equal Weight
One way to add diversification to the typical market-cap-weighted S&P 500 exposure is to stay in the same companies but use an equal-weight approach. This strategy, which can be deployed using an ETF — such as RSP
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The equal-weight index also has a lower price-to-earnings ratio (19x) than the market-cap-weighted index (22.5x) because it is less exposed to the trillion-dollar, high-growth, high-P/E technology stocks that dominate the S&P 500. In other words, investors worried about the rising valuations of giant technology firms can reduce the risk of a correction in P/E multiples in the event of a recession or some other event.
Microsoft, Nvidia and Apple each have a market capitalization of more than $3 trillion, together accounting for more than 20% of the index. To put the concentration risk into context, the 50th largest company in the S&P 500 is currently Philip Morris, with a 0.36% weight. Philip Morris would have to rise or fall by approximately 20% to have the same impact on the index as a 1% move in Microsoft, which has a 7% weight.
While adding diversification, equal-weight ETFs have some risk. They tend to have higher exposure to smaller companies, which can be more volatile than large-cap stocks. They also tend to have higher management fees due to higher trading costs and the need to rebalance every quarter.
Add More Small Cap Exposure
Small-cap stocks are companies with less than $2 billion in market capitalization. These companies often have higher growth potential compared to large-cap stocks and have provided higher returns over the long term. One of the most liquid ways to get exposure to small-cap companies is through IWM
The performance of small-cap stocks has lagged large caps over the last few years. IWM, for example, is still 17% below its 2021 high-water mark while the S&P 500 is hitting new highs. Should small-cap stocks return to favor, the gap in past performance could narrow.
One reason for the recent underperformance of smaller companies relative to the S&P 500’s large-cap stocks is sensitivity to interest rates. Small-cap stocks typically have higher leverage and lower debt service coverage ratios. So, the rise in interest rates over the last two years has led to a disproportionately negative impact on stocks in the small-cap universe. Now that inflation is falling, a corresponding drop in interest rates could be the catalyst that begins to close the gap in performance between IWM and the S&P 500.
Small-cap stocks are generally more volatile and can experience more significant price swings, especially during economic downturns. As mentioned above, they are also relatively sensitive to changes in interest rates. So, a resurgence of inflation and a subsequent shift higher in yields could dampen performance. Still, small caps are currently at the cheapest level in years compared to large caps, making them an attractive diversification alternative.
Include An Allocation To International Equities
When it comes to diversification, many investors are underweight international equities in their portfolios. International ETFs provide exposure to companies outside the U.S., offering geographic diversification and reducing reliance on the U.S. market. Investing in international stocks can also provide currency diversification, which can be beneficial in times of U.S. dollar weakness.
An easy, low-cost way to get exposure to international equities is through the Vanguard All-World Ex-U.S. ETF, VXUS
Like U.S. small-cap stocks, international equities have lagged the S&P 500 in recent years. The strength of the U.S. dollar, lower exposure to growth stocks, and slower earnings growth are a few reasons for the underperformance. From a valuation perspective, international stocks are comparably cheap. The P/E ratio of VXUS is 14.9, which is at a multidecade low relative to the S&P 500.
International investments are subject to political, economic, and regulatory risks that may not be present in the U.S. market. Also, fluctuations in exchange rates can impact the returns of international ETFs and add additional volatility. Even with some incremental risks, the diversification benefits of adding international equities to a portfolio should not be overlooked.
The S&P 500's performance over the last decade has been stellar. The concept of U.S. exceptionalism is real. Robust capital markets, technological innovation, labor flexibility, and significant fiscal stimulus measures have contributed to exceptional economic growth and stock market performance. This has also led to record-high concentration levels of the S&P 500.
The increasing concentration in the S&P 500 poses significant risks for investors seeking diversification. Investors can reduce risk and enhance their portfolios' diversification by considering alternatives such as equal-weight S&P 500 ETFs, small-cap ETFs, and diversified large-cap international ETFs. Even Warren Buffett might agree.
