Is the S&P 500 Too Concentrated?
Summary
TLDRThe video discusses concerns over the S&P 500 becoming overly concentrated in a handful of large tech stocks, which now make up a significant portion of the index's market capitalization and performance. It analyzes the validity of these concerns, noting both pros and cons - while concentration has increased, it's not unprecedented. Ultimately, the S&P 500 remains representative of the US market, but investors should understand they are making some implicit bets on factors like large caps and US stocks. Alternate index investing options with different exposures are also highlighted for those wanting a more passive strategy.
Takeaways
- 😀 The S&P 500 is becoming more concentrated in top large-cap tech stocks, raising concerns about diversification and exposure to overvalued companies
- 😮 The top 10 S&P 500 companies now represent about 1/3 of the index's total market cap, the highest since the 1970s
- 📈 But historically the index has seen similar or even higher levels of concentration in the past
- 😕 The index's increased concentration comes from the mega-cap tech stocks becoming more expensive relative to other companies
- 🤔 Some claim index investing itself is causing inflated valuations, but active trading still outweighs passive investing
- 💡 The S&P 500 aims to represent the US stock market, and still captures 80% of total market cap
- 🤨 Putting money in the S&P 500 involves some active bets - on US large caps over small caps, tech sectors, and US vs international markets
- 📉 The index has exposure beyond just the top 10 names, and overall diversification isn't yet severely hampered
- 🔎 Alternatives like equal-weight and total market indexes can provide broader diversification
- 😊 The S&P 500 has still been a solid investment over long periods, but concentration is a risk to weigh
Q & A
What percentage of the global stock market does the US stock market represent despite only being 25% of the global economy?
-The US stock market represents roughly 60% of the global stock market capitalization despite the country only representing 25% of the global economy measured by GDP.
What is the current average PE multiple for the S&P 500 versus other markets?
-The S&P 500 currently trades at an average PE multiple of 24.2 times versus 16.5 times for the Canadian S&P TSX Composite and cheaper valuations for many other international markets.
What were the two main reasons given for why smaller cap stocks tend to earn higher returns over the long term?
-The two main reasons are that smaller companies tend to have an easier time growing their operations since they are less mature and established, and larger companies tend to already have high valuations baked in relative to their future earnings growth potential.
What percentage of the S&P 500 earnings in 2024 is expected to come from the Magnificent 7 companies?
-The Magnificent 7 companies are only expected to contribute 19.5% of the S&P 500's earnings in 2024 despite representing 28.6% of its market capitalization in the prior year.
How many stocks are technically included in the S&P 500?
-While referred to as the top 500 companies, the S&P 500 technically includes 505 stocks currently due to some companies having multiple share classes included.
What time period saw a peak in concentration level for the S&P 500's top 10 holdings?
-Concentration for the S&P 500's top 10 holdings peaked above 40% back in the 1960s before coming down closer to 30% for much of the 1970s.
What are some other broad market index alternatives mentioned besides the S&P 500?
-Some other broad market index alternatives mentioned include the S&P Total Market Index, Russell 3000 Index, CRSP US Total Market Index, and MSCI World Index.
What two criteria must a company meet to qualify for inclusion in the S&P 500?
-Two of the main criteria for a company to be added to the S&P 500 are having positive as-reported earnings and adequate liquidity.
What is tracking error and why does it matter when selecting an index fund?
-Tracking error refers to how closely an index fund mimics the actual performance of the underlying index. Minimizing tracking error is important to ensure your index fund investment effectively matches the benchmark.
How can investors mitigate the concentration risk of the S&P 500 highlighted in the passage?
-Investors can mitigate the concentration risk by investing in an equal-weighted S&P 500 fund, exploring other broader market indexes, or diversifying internationally into stocks outside the US market.
Outlines
📈 Intro to Investing in the S&P 500 Index
The paragraph introduces the S&P 500 index, which tracks the top 500 US companies. It discusses the index's historical performance, popularity among investors, and recent concerns over concentration risk.
📉 Evaluating the Diversification and Concentration Issues
The paragraph evaluates the diversification and concentration issues of the S&P 500. It analyzes the trends driving increased concentration, perspectives on index investing, and benchmarks the S&P 500 against other indices.
🤔 Historical Context and Caveats to S&P 500 Investing
The paragraph provides historical context showing similar periods of concentration in the past. It also highlights caveats with S&P 500 investing, like the discretionary inclusion criteria and inherent bets compared to broader market indices.
🌎 Considering Different Indexing Approaches and Global Exposure
The paragraph suggests alternative indexing approaches to mitigate concentration risk, like equal-weighted and total market funds. It also notes the S&P 500's inherent bet on US large-caps over global stocks.
Mindmap
Keywords
💡S&P 500
💡index investing
💡market capitalization
💡concentration
💡valuation
💡diversification
💡active investing
💡price discovery
💡asset bubble
💡historical range
Highlights
Investing in the S&P 500 is a popular form of investing advice given its exposure to some of the strongest companies historically
The S&P 500 has seen an 11.1% average annual return over the past 50 years, outperforming most actively managed funds
$7.1 trillion is now directly linked to the S&P 500, double the amount from 3 years ago, raising concentration risk concerns
A group called the Magnificent 7 accounted for 2/3 of the S&P 500's returns in 2021, showing the impact of concentration
Some claim index investing is worse than Marxism by impacting price discovery and contributing to asset bubbles
Active managers have a conflict of interest in criticizing index funds that have taken business away from them
The S&P 500 is getting more concentrated around a few large companies across a couple sectors that are more expensive
The S&P 500 still captures 80% of the US stock market, so it's reasonably representative despite some issues
S&P 500 concentration has been higher historically, peaking above 40% in the 1960s for the top 10 positions
The S&P 500 is less concentrated than indices for markets like Germany and China
Research shows a portfolio is reasonably diversified with less than 5% in a single position; Apple and Microsoft are just at that threshold
Buying the S&P 500 means betting on US large caps outperforming smaller caps, despite research suggesting otherwise long-term
The S&P 500 uses some discretion, including sector weighting, in determining constituents, rather than pure market cap weighting
Valuations suggest the US market is expensive compared to international markets, so S&P 500 bets on continued US dominance
Other index alternatives can provide broader diversification, like total market or equal-weighted funds
Transcripts
ladies and gentlemen welcome to the
plane bagle I'm your host Richard coffin
investing in the S&P 500 is pretty
easily one of the most popular forms of
investing advice you'll come across
online after all it's an index of the
top 500 companies in the United States
so a lot of people view it as a very
easy way to diversify your money and get
exposure to some of the strongest
companies in what's historically been
one of the strongest stock markets in
the world with even Warren Buffett
himself encouraging investors to just
stick their money into an S&P 500 Index
Fund buy an S&P 500 lowcost Index Fund
keep buying it through thick and thin
and especially through thin if anyone
followed that advice it's worked out
pretty nicely for them over the last 50
years the S&P 500 has seen an average
total annual return so inclusive of
dividends of
11.1% which is pretty good and actually
outperforms the majority of equity-based
actively managed funds but as you might
have heard there's been some growing
murmuring over the Integrity of the S&P
500 and whether it's still a diversified
investment you see given how well this
simple strategy has worked out over the
years we've seen a lot of money start
tracking the index with there being $7.1
trillion directly linked to the S&P 500
as of 2021 year end uh which is actually
double the amount it was 3 years prior
and that's led to the concern that all
this money flowing into these index
products is inflating the value of its
constituents namely for the largest
companies by market capitalization uh
which increases the risk of
concentration that just a handful of
positions will dominate the performance
of the overall index uh for example last
year a group dubbed the Magnificent 7
which includes Apple Microsoft alphabet
Amazon Nvidia meta and Tesla alone
accounted for roughly 2third of the
entire index's returned for the year
which you can really see the impact of
when you graph the performance of the
S&P 500 excluding these seven positions
now this is far from the first time
we've seen alarm Bells rung over the S&P
500 and even index investing as a whole
with a lot of active investors
criticizing the practice for impacting
price Discovery with the the idea being
that if all these investors this $7
trillion of money is just being parked
into these companies without any real
fundamental research it's going to lead
those positions to become inflated and
could contribute to a bubble given that
we aren't seeing buying and selling
activity based on the company's
fundamentals or uh Research into the
business with one paper in 2016 even
claiming that index investing was worse
than Marxism which is a pretty alarming
claim but it's always been important to
take this alarm's commentary with a
grain of salt given not only that the
S&P 500 has continued to perform well
over the long term but also that active
investors have a very clear conflict of
interest here which is that index funds
have actually taken away a lot of their
business given their cheaper fund
structure uh so of course an active fund
manager who's losing business is going
to claim that their competitor
represents the end of capitalism as we
know it so we have seen the
concentration of the S&P 500 increase
over time so there are some valid points
being raised here uh and there's also a
lot of misconceptions about what
investing in the S&P 500 entails today I
want want to address the diversification
concerns describe the situation and
hopefully put it into perspective and
then also highlight some important
details about how this Compares uh
historically to what we've seen with the
index and it be perfectly clear so I
don't misrepresent the situation no uh
none of this is to suggest that
investing into the S&P 500 has suddenly
become a bad or risky investment only
time will tell whether it outperforms or
underperforms other strategies but it's
really not as dire of a situation as
some articles might suggest still if
you're going to put your money into the
S&P 500 you should be aware of what
you're buying and what you aren't uh
because despite being synonymous with
index investing itself and the idea of
passive investing you are sort of making
some active calls when you put your
money into the S&P 500 so today's video
we'll cover all that as well as uh how
compares to other indexing strategies
but let's start by addressing the
diversification concerns as a market
capw weighted index versus say an equal
weighted index where every constituent
is given an equal share of the overall
uh index uh the S&P 500 gives a larger
weight to companies with higher market
capitalizations so the larger the
company the bigger its representation in
the index and the bigger it's impact on
that figure and a lot of people have
always argued that that makes sense to
represent the stock market that uh the
index is trying to gauge because if
companies like apple and Microsoft are
the biggest companies in the United
States and have the largest impact on
the market given the sheer size of their
operations then they should have a
higher representation than a company
that say has much smaller operations but
over time we've seen the market
capitalization for these companies
outpace the earnings they achieve
meaning there's been an expansion of
their valuation as an example of this
last year the magnificon 7 who are all
part of the top 10 companies by market
cap accounted for 28.6% of the S&P 500's
market capitalization but is only
expected to make up
19.5% of the index's earnings for 2024
in other words larger companies are
becoming more expensive relative to
smaller companies now a lot of this
could be related to the hype around
artificial intelligence you might have
noticed that the Magnificent Seven stock
all pretty well involved with artificial
intelligence and are trying to
incorporate it into their future
business models so it could be justified
that the reason these stocks are more
expensive is because they're more likely
uh to see higher growth in the future
given that they're playing in the space
on the other side of it though some fear
that this is the result of a sort of
positive feedback loop resulting from
index investing uh price of a large cap
stock increases which increases its
weight within the S&P 500 which leads to
more index investing dollars going
towards that company which further
increases the stock price in its
valuation repeating the cycle over and
over again we have seen this phenomenon
where the largest constituents of the
index have grown faster than the rest of
the participants uh leading to more and
more concentration among them for
example the top 10 positions of the S&P
500 or just 2% of all companies on the
index represent roughly onethird of the
entire index's market capitalization
which is essentially the highest it's
been since the 70s and it's most evident
when you look at the top two positions
of the index Microsoft and Apple which
Al alone represent nearly 14% of the
entire S&P 500 and because a lot of
these companies are within the it and
communication sectors uh which
historically were actually in part a
single category we've also seen sector
concentration increase with those two
representing 38.4% of the index despite
them being just two of 11 categories and
that's really the Crux of the situation
the S&P 500 is getting more and more
concentrated around just a handful of
positions uh across just a couple of
sectors and those positions are more
expensive than much of the rest of the
index uh which could raise concerns that
investors are getting more exposure to
expensive stocks but before reaching a
verdict on this it's worth highlighting
some other important details for one
with the S&P 500 still accounting for
roughly 80% of the entire US Stock
markets market capitalization it is
still roughly representative of the US
Stock Market now we've highlighted the
drawbacks of market capitalization given
that it's a valuation-based metric and
can deviate from the actual operations
or size of a company or how much money
it's making but nonetheless even with
some issue there with 80% of the market
being captured these 500 of the roughly
4,000 publicly traded stocks are still
going to be representative of most of
what the market is doing secondly it's
worth highlighting that this isn't the
first time the S&P 500 has been topheavy
uh in fact there's been periods in the
past where it's actually been more
concentrated the weight of the top 10
positions in the S&P 500 peaked above
40% back in the 1960s and even stayed
above the 30% level up until the mid
1970s with more recently it peing above
25 % during the com bubble versus today
where the top 10 represent 32% so yes
that is higher than perhaps the
long-term average that we've seen uh but
it's not outside the historical range
that we've ever seen for concentration
thirdly the S&P 500 is far from being
the most concentrated index out there
other indices for Germany China and
other investable markets actually have a
much higher concentration among their
top 10 positions with us here in Canada
likewise having a higher concentration
with the top 10 representing
36.6% of our S&P TSX Composite Index so
from that standpoint the S&P 500 isn't
doing too bad finally while a lot of
people take comfort in buying the s&p500
given that it gives them exposure to
again 500 and three technically
different stocks just because some
companies have multiple share classes uh
you don't need 500 different stocks to
be Diversified in a given Market a lot
of research highlights that the marginal
benefit of diversification to standard
deviation or how much the portfolio
moves around really tapers off after 20
to 30 positions mean that after that
point you're not further stabilizing
your portfolio by adding more positions
or at least not meaningfully so roughly
speaking an equity portfolio would be
considered Diversified on the generous
end of things if it had less than 5% of
its money into a single position now it
is worth highlighting that apple and
Microsoft do violate this both having
more than 5% uh of the overall index uh
but it's far from a detrimental
allocation yes there's a bit of an
overweight here and that could become
more of a problem if these positions
continue to outperform which would
benefit you but none n thess would
increase the risk from that point moving
forward at just 13% of the overall
portfolio it's not yet at a level where
we're severely seeing diversification
hampered on top of this while the top 10
positions for the S&P 500 are likely
more correlated something that matters
for diversification since it makes it
less effective S&P Global actually posts
data on the S&P 500 constituents
correlation over time and at a current
0.18 you can see that there's still some
diversification benefit to the index so
that should address the worst concerns
over diversification uh now there are
are deeper longer running debates over
again whether index investing is causing
asset bubbles especially with those
larger cap positions uh there we have
addressed some of that in the past with
a big caveat to that argument being that
active trading activity still far
outweighs passive trading activity so
while yes a lot of people are buying and
holding positions it's that active
trading that will contribute to the
price Discovery so long as that still
outweighs the Buy and Hold activity of
uh the passive investors and yes there
is a chance that as valuations expand
further and further we could see a
correction of the top positions of the
S&P 500 as more active investors sort of
Arbitrage into the space and correct
that mispricing and maybe we see a
period of underperformance as a result
of that for example the S&P 500 saw a
total return average of 6.2% a year from
the end of 1963 roughly when that
concentration had peaked uh to the end
of the 70s but over the very long term
despite these periods of of weaker
growth we've still seen the S&P 500 see
a double digigit Total return figure and
given that index investing still has a
cost advantage over active investing it
doesn't really poke a hole in in the
viability of the S&P 500 nonetheless
this is where I want to highlight some
of the fine print to investing in the
S&P 500 because while that is sort of
synonymous with the idea of passive
index investing as mentioned when you
decide to put your money into the S&P
500 you are in some ways making an
active strategic call whether you know
it or not for one while the S&P 500 is
often highlighted as the top 500
companies by market capitalization
that's not always true strictly speaking
the index is actually a committee
determined index meaning that there are
people who will decide based on a list
of criteria whether a stock gets to be
included or not and that comes with a
bit of discretion on their part the
other criteria in addition to market cap
includes having positive as reported
earnings adequate liquidity and there's
even a bit of discretionary sector
waiting involved so that's the first
point is that again the strategy
involves a bit more discretion from the
committee and in terms of this criteria
than you might expect as a passive
investor uh the second point is that in
buying the S&P 500 you are clearly
making a bet on larger cap stocks
outperforming smaller cap positions now
over the last decade we have seen larger
cap positions outperform in part because
we've seen their valuation continue to
expand the law research suggests that
over the long term smaller cap positions
tend to earn a larger return in fact if
you compare the S&P 500 to the S&P 600
which is actually a small cap index of
600 small cap US Stocks yes the S&P 500
did outperform over the last 10 years
but over the last 30 years the S&P 600
has outperformed by an average annual
4.5% on a price basis now that's
exclusive of dividends which the S&P 500
would be paying more of but regardless
on a total return basis the S&P 600
would still be ahead and as for why we
see this there are two sort of
theoretical explanations at the first
being that smaller cap companies tend to
have an easier time growing their
operations than a large company that's
already well established and more mature
and secondly the larger cap companies
again tend to demand a valuation premium
meaning that a lot of their future
growth is already baked into the current
stock price so whereas a smaller cap
company has room for both earnings
growth and valuation expansion larger
cap companies have already seen their
valuations expand and are already at an
elevated level which brings us to the
final caveat worth highlighting which is
that clearly the S&P 500 means that
you're actively bedding on the US Stock
Market versus International stock
markets now I know investors love the US
Stock Market and there's good reason for
that it's been a very strong performer
historically uh but you are still buying
into what is one of the most expensive
markets globally when there are a lot of
opportunities internationally ly as well
the US Stock Market for example
currently represents roughly 60% of the
global stock market market
capitalization despite the country only
representing 25% of the global economy
measured by GDP now stock markets and
economies are not directly comparable so
we are in some way comparing apples and
oranges here but it does still go to
show that the market is relatively
expensive using PE multiples for example
or the price of a stock relative to the
earnings of the underlying company the
S&P 500 currently trades at an average
24.2 times versus the Canadian S&P TSX
composite at 16.5 times and many other
International markets which trade at
much cheaper valuations now does this
mean that the US markets Glory Days are
behind them uh well maybe I don't know
but no not directly um yes valuations
are stretch and that does mean there is
a risk of contraction but there really
is no predicting the future there's no
telling how long stocks could stay at
this sort of elevated level I highlight
all this not to say that the US market
or the S&P 500 are going to underperform
but just to highlight that if if you put
your money into the S&P 500 while you
might view yourself as a passive
investor you are still making some
active bets you're essentially betting
that us large market cap positions are
going to outperform with a particular
weight towards it communication and more
specifically Microsoft and Apple and I
want to emphasize none of this is to
hate on the S&P 500 I think it's been a
great option for a lot of people there's
a good reason to buy into companies that
are profitable and have a strong
developed moat and almost Monopoly in
some of the industries they operate
within but that is the thesis this you
are betting on now perhaps you're
someone who wants to take advantage of
index investing but doesn't necessarily
like the idea of making those active
calls and just wants more broad Market
exposure there are a lot of options even
within just the US market for different
sorts of allocations thep super comp for
example includes the sp500 the S&P 600
as well as the S&P 400 which is a midcap
index to capture more of the stock
market it is still a market cap weighted
index so you are still going to be
topheavy with those positions but
perhaps less so and you'll also get
exposure to those smaller cap positions
there are also other indexes with an
even broader reach than the S&P indices
such as the Russell 3000 and the crsp or
crisp us total market index which
actually includes 100% of the US
investable Equity market and even within
the S&P 500 there are equal weighted
funds where you still get that large cap
exposure uh but you split the money more
evenly across all the constituents with
this fund having outperformed the normal
S&P 500 on a total return basis over the
last 20 years OB be there are periods
where the normal index is ahead uh so it
could outperform it could under perform
only time will tell uh but another
option there as well and internationally
there are a lot of indices you can have
an index fund for as well uh whether it
be for a specific country or Glo a
globally Diversified one such as the
msci world index so it's worth
researching all the options out there
and all the different indues as well as
all the different index funds because
you don't actually put money directly
into the S&P 500 you're buying a fund
that tracks the S&P 500 so it's worth
looking into things like the fee that
fund charges obviously you want to
minimize that as best as possible as
well as the tracking error of the fund
because some funds don't perfectly mimic
the index so the smaller that figure the
more closely the index fund copies the
index in question so certainly with all
this the concentration risk is something
to be aware of again to know that you do
have that higher exposure but that can
be mitigated in any number of ways if
you want to or you can just be aware
that that's the bet you're taking and
that might work out it might not um you
might outperform in some years you might
underperform in others generally
speaking if you are broadly speaking
Diversified which I still think the S&P
500 is um it's still a viable option and
should generally be happy with the
market returns you see anyway that's the
video thanks for joining me today I hope
you found it helpful if you did please
make sure to like subscribe all that
good stuff it does help the channel
tremendously and let me know your
thoughts on investing in the S&P 500
obviously I hate to say it but not
Financial advice really try not to
influence people's decisions just lay
out the details so you can come to your
own conclusions about what index
investing strategy works for you if
that's the approach you want to take uh
thanks again for joining and as always
be safe out there
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