Is the S&P 500 Too Concentrated?

Summary

The 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.

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

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