Is the S&P 500 Too Concentrated?

The Plain Bagel
1 Mar 202416:57

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

00:00

📈 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.

05:02

📉 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.

10:03

🤔 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.

15:06

🌎 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

The S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It is one of the most commonly used benchmarks for the overall U.S. stock market. The video discusses concerns over the S&P 500 becoming too concentrated in a handful of large tech stocks.

💡index investing

Index investing means investing in an index fund that tracks and replicates the holdings and performance of a market index like the S&P 500. The video talks about debates over whether the rise of index investing is inflating stock prices.

💡market capitalization

A company's market capitalization (market cap) refers to its total market value based on its current share price and number of shares outstanding. The S&P 500 weights companies by market cap, so larger companies have an outsized impact.

💡concentration

Concentration refers to the index becoming overly focused on a small number of companies, sectors, or industries. The video discusses concerns that the S&P 500 is getting too concentrated in a few mega-cap tech stocks.

💡valuation

Valuation refers to the current price of a stock relative to a fundamental metric like earnings. The video notes that top S&P 500 companies have high valuations that may not be justified by earnings growth.

💡diversification

Diversification means spreading investments across different assets to reduce risk. Despite tracking 500 stocks, concerns are being raised over whether the S&P 500 is still adequately diversified.

💡active investing

Active investing refers to picking individual stocks based on research, as opposed to passive index investing. The video notes criticisms of index investing from active investors.

💡price discovery

Price discovery is the process of buyers and sellers arriving at an agreed market price based on supply and demand. Critics argue index investing could distort price discovery.

💡asset bubble

An asset bubble refers to artificially inflated prices that eventually correct. Critics suggest index investing money flows may be inflating a bubble in mega-cap tech stocks.

💡historical range

This refers to the range of values or metrics seen historically for something like S&P 500 concentration levels. The video notes that while concentration is elevated currently, it has been higher at times in the past.

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

play00:00

ladies and gentlemen welcome to the

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plane bagle I'm your host Richard coffin

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investing in the S&P 500 is pretty

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easily one of the most popular forms of

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investing advice you'll come across

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online after all it's an index of the

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top 500 companies in the United States

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so a lot of people view it as a very

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easy way to diversify your money and get

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exposure to some of the strongest

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companies in what's historically been

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one of the strongest stock markets in

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the world with even Warren Buffett

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himself encouraging investors to just

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stick their money into an S&P 500 Index

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Fund buy an S&P 500 lowcost Index Fund

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keep buying it through thick and thin

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and especially through thin if anyone

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followed that advice it's worked out

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pretty nicely for them over the last 50

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years the S&P 500 has seen an average

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total annual return so inclusive of

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dividends of

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11.1% which is pretty good and actually

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outperforms the majority of equity-based

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actively managed funds but as you might

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have heard there's been some growing

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murmuring over the Integrity of the S&P

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500 and whether it's still a diversified

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investment you see given how well this

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simple strategy has worked out over the

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years we've seen a lot of money start

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tracking the index with there being $7.1

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trillion directly linked to the S&P 500

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as of 2021 year end uh which is actually

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double the amount it was 3 years prior

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and that's led to the concern that all

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this money flowing into these index

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products is inflating the value of its

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constituents namely for the largest

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companies by market capitalization uh

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which increases the risk of

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concentration that just a handful of

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positions will dominate the performance

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of the overall index uh for example last

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year a group dubbed the Magnificent 7

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which includes Apple Microsoft alphabet

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Amazon Nvidia meta and Tesla alone

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accounted for roughly 2third of the

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entire index's returned for the year

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which you can really see the impact of

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when you graph the performance of the

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S&P 500 excluding these seven positions

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now this is far from the first time

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we've seen alarm Bells rung over the S&P

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500 and even index investing as a whole

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with a lot of active investors

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criticizing the practice for impacting

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price Discovery with the the idea being

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that if all these investors this $7

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trillion of money is just being parked

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into these companies without any real

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fundamental research it's going to lead

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those positions to become inflated and

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could contribute to a bubble given that

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we aren't seeing buying and selling

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activity based on the company's

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fundamentals or uh Research into the

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business with one paper in 2016 even

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claiming that index investing was worse

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than Marxism which is a pretty alarming

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claim but it's always been important to

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take this alarm's commentary with a

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grain of salt given not only that the

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S&P 500 has continued to perform well

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over the long term but also that active

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investors have a very clear conflict of

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interest here which is that index funds

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have actually taken away a lot of their

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business given their cheaper fund

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structure uh so of course an active fund

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manager who's losing business is going

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to claim that their competitor

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represents the end of capitalism as we

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know it so we have seen the

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concentration of the S&P 500 increase

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over time so there are some valid points

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being raised here uh and there's also a

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lot of misconceptions about what

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investing in the S&P 500 entails today I

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want want to address the diversification

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concerns describe the situation and

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hopefully put it into perspective and

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then also highlight some important

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details about how this Compares uh

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historically to what we've seen with the

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index and it be perfectly clear so I

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don't misrepresent the situation no uh

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none of this is to suggest that

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investing into the S&P 500 has suddenly

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become a bad or risky investment only

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time will tell whether it outperforms or

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underperforms other strategies but it's

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really not as dire of a situation as

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some articles might suggest still if

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you're going to put your money into the

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S&P 500 you should be aware of what

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you're buying and what you aren't uh

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because despite being synonymous with

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index investing itself and the idea of

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passive investing you are sort of making

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some active calls when you put your

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money into the S&P 500 so today's video

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we'll cover all that as well as uh how

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compares to other indexing strategies

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but let's start by addressing the

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diversification concerns as a market

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capw weighted index versus say an equal

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weighted index where every constituent

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is given an equal share of the overall

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uh index uh the S&P 500 gives a larger

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weight to companies with higher market

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capitalizations so the larger the

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company the bigger its representation in

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the index and the bigger it's impact on

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that figure and a lot of people have

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always argued that that makes sense to

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represent the stock market that uh the

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index is trying to gauge because if

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companies like apple and Microsoft are

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the biggest companies in the United

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States and have the largest impact on

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the market given the sheer size of their

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operations then they should have a

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higher representation than a company

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that say has much smaller operations but

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over time we've seen the market

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capitalization for these companies

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outpace the earnings they achieve

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meaning there's been an expansion of

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their valuation as an example of this

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last year the magnificon 7 who are all

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part of the top 10 companies by market

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cap accounted for 28.6% of the S&P 500's

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market capitalization but is only

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expected to make up

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19.5% of the index's earnings for 2024

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in other words larger companies are

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becoming more expensive relative to

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smaller companies now a lot of this

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could be related to the hype around

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artificial intelligence you might have

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noticed that the Magnificent Seven stock

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all pretty well involved with artificial

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intelligence and are trying to

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incorporate it into their future

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business models so it could be justified

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that the reason these stocks are more

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expensive is because they're more likely

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uh to see higher growth in the future

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given that they're playing in the space

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on the other side of it though some fear

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that this is the result of a sort of

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positive feedback loop resulting from

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index investing uh price of a large cap

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stock increases which increases its

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weight within the S&P 500 which leads to

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more index investing dollars going

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towards that company which further

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increases the stock price in its

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valuation repeating the cycle over and

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over again we have seen this phenomenon

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where the largest constituents of the

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index have grown faster than the rest of

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the participants uh leading to more and

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more concentration among them for

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example the top 10 positions of the S&P

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500 or just 2% of all companies on the

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index represent roughly onethird of the

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entire index's market capitalization

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which is essentially the highest it's

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been since the 70s and it's most evident

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when you look at the top two positions

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of the index Microsoft and Apple which

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Al alone represent nearly 14% of the

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entire S&P 500 and because a lot of

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these companies are within the it and

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communication sectors uh which

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historically were actually in part a

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single category we've also seen sector

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concentration increase with those two

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representing 38.4% of the index despite

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them being just two of 11 categories and

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that's really the Crux of the situation

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the S&P 500 is getting more and more

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concentrated around just a handful of

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positions uh across just a couple of

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sectors and those positions are more

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expensive than much of the rest of the

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index uh which could raise concerns that

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investors are getting more exposure to

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expensive stocks but before reaching a

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verdict on this it's worth highlighting

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some other important details for one

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with the S&P 500 still accounting for

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roughly 80% of the entire US Stock

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markets market capitalization it is

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still roughly representative of the US

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Stock Market now we've highlighted the

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drawbacks of market capitalization given

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that it's a valuation-based metric and

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can deviate from the actual operations

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or size of a company or how much money

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it's making but nonetheless even with

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some issue there with 80% of the market

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being captured these 500 of the roughly

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4,000 publicly traded stocks are still

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going to be representative of most of

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what the market is doing secondly it's

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worth highlighting that this isn't the

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first time the S&P 500 has been topheavy

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uh in fact there's been periods in the

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past where it's actually been more

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concentrated the weight of the top 10

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positions in the S&P 500 peaked above

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40% back in the 1960s and even stayed

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above the 30% level up until the mid

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1970s with more recently it peing above

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25 % during the com bubble versus today

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where the top 10 represent 32% so yes

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that is higher than perhaps the

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long-term average that we've seen uh but

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it's not outside the historical range

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that we've ever seen for concentration

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thirdly the S&P 500 is far from being

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the most concentrated index out there

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other indices for Germany China and

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other investable markets actually have a

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much higher concentration among their

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top 10 positions with us here in Canada

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likewise having a higher concentration

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with the top 10 representing

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36.6% of our S&P TSX Composite Index so

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from that standpoint the S&P 500 isn't

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doing too bad finally while a lot of

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people take comfort in buying the s&p500

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given that it gives them exposure to

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again 500 and three technically

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different stocks just because some

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companies have multiple share classes uh

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you don't need 500 different stocks to

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be Diversified in a given Market a lot

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of research highlights that the marginal

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benefit of diversification to standard

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deviation or how much the portfolio

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moves around really tapers off after 20

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to 30 positions mean that after that

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point you're not further stabilizing

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your portfolio by adding more positions

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or at least not meaningfully so roughly

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speaking an equity portfolio would be

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considered Diversified on the generous

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end of things if it had less than 5% of

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its money into a single position now it

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is worth highlighting that apple and

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Microsoft do violate this both having

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more than 5% uh of the overall index uh

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but it's far from a detrimental

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allocation yes there's a bit of an

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overweight here and that could become

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more of a problem if these positions

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continue to outperform which would

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benefit you but none n thess would

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increase the risk from that point moving

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forward at just 13% of the overall

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portfolio it's not yet at a level where

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we're severely seeing diversification

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hampered on top of this while the top 10

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positions for the S&P 500 are likely

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more correlated something that matters

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for diversification since it makes it

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less effective S&P Global actually posts

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data on the S&P 500 constituents

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correlation over time and at a current

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0.18 you can see that there's still some

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diversification benefit to the index so

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that should address the worst concerns

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over diversification uh now there are

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are deeper longer running debates over

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again whether index investing is causing

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asset bubbles especially with those

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larger cap positions uh there we have

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addressed some of that in the past with

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a big caveat to that argument being that

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active trading activity still far

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outweighs passive trading activity so

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while yes a lot of people are buying and

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holding positions it's that active

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trading that will contribute to the

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price Discovery so long as that still

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outweighs the Buy and Hold activity of

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uh the passive investors and yes there

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is a chance that as valuations expand

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further and further we could see a

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correction of the top positions of the

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S&P 500 as more active investors sort of

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Arbitrage into the space and correct

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that mispricing and maybe we see a

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period of underperformance as a result

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of that for example the S&P 500 saw a

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total return average of 6.2% a year from

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the end of 1963 roughly when that

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concentration had peaked uh to the end

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of the 70s but over the very long term

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despite these periods of of weaker

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growth we've still seen the S&P 500 see

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a double digigit Total return figure and

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given that index investing still has a

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cost advantage over active investing it

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doesn't really poke a hole in in the

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viability of the S&P 500 nonetheless

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this is where I want to highlight some

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of the fine print to investing in the

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S&P 500 because while that is sort of

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synonymous with the idea of passive

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index investing as mentioned when you

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decide to put your money into the S&P

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500 you are in some ways making an

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active strategic call whether you know

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it or not for one while the S&P 500 is

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often highlighted as the top 500

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companies by market capitalization

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that's not always true strictly speaking

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the index is actually a committee

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determined index meaning that there are

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people who will decide based on a list

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of criteria whether a stock gets to be

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included or not and that comes with a

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bit of discretion on their part the

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other criteria in addition to market cap

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includes having positive as reported

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earnings adequate liquidity and there's

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even a bit of discretionary sector

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waiting involved so that's the first

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point is that again the strategy

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involves a bit more discretion from the

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committee and in terms of this criteria

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than you might expect as a passive

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investor uh the second point is that in

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buying the S&P 500 you are clearly

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making a bet on larger cap stocks

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outperforming smaller cap positions now

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over the last decade we have seen larger

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cap positions outperform in part because

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we've seen their valuation continue to

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expand the law research suggests that

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over the long term smaller cap positions

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tend to earn a larger return in fact if

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you compare the S&P 500 to the S&P 600

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which is actually a small cap index of

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600 small cap US Stocks yes the S&P 500

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did outperform over the last 10 years

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but over the last 30 years the S&P 600

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has outperformed by an average annual

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4.5% on a price basis now that's

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exclusive of dividends which the S&P 500

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would be paying more of but regardless

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on a total return basis the S&P 600

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would still be ahead and as for why we

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see this there are two sort of

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theoretical explanations at the first

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being that smaller cap companies tend to

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have an easier time growing their

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operations than a large company that's

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already well established and more mature

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and secondly the larger cap companies

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again tend to demand a valuation premium

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meaning that a lot of their future

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growth is already baked into the current

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stock price so whereas a smaller cap

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company has room for both earnings

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growth and valuation expansion larger

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cap companies have already seen their

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valuations expand and are already at an

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elevated level which brings us to the

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final caveat worth highlighting which is

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that clearly the S&P 500 means that

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you're actively bedding on the US Stock

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Market versus International stock

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markets now I know investors love the US

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Stock Market and there's good reason for

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that it's been a very strong performer

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historically uh but you are still buying

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into what is one of the most expensive

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markets globally when there are a lot of

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opportunities internationally ly as well

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the US Stock Market for example

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currently represents roughly 60% of the

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global stock market market

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capitalization despite the country only

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representing 25% of the global economy

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measured by GDP now stock markets and

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economies are not directly comparable so

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we are in some way comparing apples and

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oranges here but it does still go to

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show that the market is relatively

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expensive using PE multiples for example

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or the price of a stock relative to the

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earnings of the underlying company the

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S&P 500 currently trades at an average

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24.2 times versus the Canadian S&P TSX

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composite at 16.5 times and many other

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International markets which trade at

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much cheaper valuations now does this

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mean that the US markets Glory Days are

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behind them uh well maybe I don't know

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but no not directly um yes valuations

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are stretch and that does mean there is

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a risk of contraction but there really

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is no predicting the future there's no

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telling how long stocks could stay at

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this sort of elevated level I highlight

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all this not to say that the US market

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or the S&P 500 are going to underperform

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but just to highlight that if if you put

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your money into the S&P 500 while you

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might view yourself as a passive

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investor you are still making some

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active bets you're essentially betting

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that us large market cap positions are

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going to outperform with a particular

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weight towards it communication and more

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specifically Microsoft and Apple and I

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want to emphasize none of this is to

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hate on the S&P 500 I think it's been a

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great option for a lot of people there's

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a good reason to buy into companies that

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are profitable and have a strong

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developed moat and almost Monopoly in

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some of the industries they operate

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within but that is the thesis this you

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are betting on now perhaps you're

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someone who wants to take advantage of

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index investing but doesn't necessarily

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like the idea of making those active

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calls and just wants more broad Market

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exposure there are a lot of options even

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within just the US market for different

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sorts of allocations thep super comp for

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example includes the sp500 the S&P 600

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as well as the S&P 400 which is a midcap

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index to capture more of the stock

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market it is still a market cap weighted

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index so you are still going to be

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topheavy with those positions but

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perhaps less so and you'll also get

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exposure to those smaller cap positions

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there are also other indexes with an

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even broader reach than the S&P indices

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such as the Russell 3000 and the crsp or

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crisp us total market index which

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actually includes 100% of the US

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investable Equity market and even within

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the S&P 500 there are equal weighted

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funds where you still get that large cap

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exposure uh but you split the money more

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evenly across all the constituents with

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this fund having outperformed the normal

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S&P 500 on a total return basis over the

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last 20 years OB be there are periods

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where the normal index is ahead uh so it

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could outperform it could under perform

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only time will tell uh but another

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option there as well and internationally

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there are a lot of indices you can have

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an index fund for as well uh whether it

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be for a specific country or Glo a

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globally Diversified one such as the

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msci world index so it's worth

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researching all the options out there

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and all the different indues as well as

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all the different index funds because

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you don't actually put money directly

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into the S&P 500 you're buying a fund

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that tracks the S&P 500 so it's worth

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looking into things like the fee that

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fund charges obviously you want to

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minimize that as best as possible as

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well as the tracking error of the fund

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because some funds don't perfectly mimic

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the index so the smaller that figure the

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more closely the index fund copies the

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index in question so certainly with all

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this the concentration risk is something

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to be aware of again to know that you do

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have that higher exposure but that can

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be mitigated in any number of ways if

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you want to or you can just be aware

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that that's the bet you're taking and

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that might work out it might not um you

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might outperform in some years you might

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underperform in others generally

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speaking if you are broadly speaking

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Diversified which I still think the S&P

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500 is um it's still a viable option and

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should generally be happy with the

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market returns you see anyway that's the

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video thanks for joining me today I hope

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you found it helpful if you did please

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make sure to like subscribe all that

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good stuff it does help the channel

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tremendously and let me know your

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thoughts on investing in the S&P 500

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obviously I hate to say it but not

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Financial advice really try not to

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influence people's decisions just lay

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out the details so you can come to your

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own conclusions about what index

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investing strategy works for you if

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that's the approach you want to take uh

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thanks again for joining and as always

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be safe out there