The Bottom Line
- With hundreds of constituents, the S&P 500 equity index would seem to be quite diversified.
- Yet a closer look reveals investors in the index may not be as diversified as they think.
- Because the S&P 500 (and many other equity indexes) are market-capitalization weighted, some stocks and sectors are represented far more than others.
- Indeed, the top 25 holdings accounted for more than one-third of the market-capitalization of the entire index (as of August 28).1
- In addition, three sectors accounted for more than half of the index’s value. And within the largest sector (Information Technology), just four stocks represented nearly half of the sector’s weight, while the remaining 64 stocks accounted for the other 50%.
- What’s more, the Information Technology sector’s weighting has increased substantially this year, from 20.77% to 23.33%. The driver, of course, was the sector’s dramatic outperformance of the overall index (24.1% to 10.6%) through August 28, 2017—thanks to big gains from the largest companies in the sector.
- What all this illustrates is that a passive index approach can easily lead to unintended exposures to certain stocks and sectors.
- Even more important, it can lead investors to miss out on opportunities in stocks whose market capitalizations are relatively small, but which may have greater future growth potential.
- Active managers, who can be selective about which stocks to own and how to weight them, are free to build portfolios that look different from the S&P 500 and other indexes, avoiding the implicit concentration risks.
- Being different from the index is by definition essential to perform better than the index over time—and to be positioned to adjust positions when markets experience periodic bouts of unexpected volatility.
1 Source for all data is Bloomberg.