By Phil Bak, CEO of Exponential ETFs

The most valuable skill an investor can acquire is the ability to distinguish theory from law. Examples of theory include forecasts, the relationship between gold and inflation, or anything ever written by an economist.

Examples of law include principles of diversification, statistical arbitrage, and mostly, the fact that anything good that ever gets posted online is done on those nights you’ve promised your girlfriend a nice dinner out and your full attention.

Michael Batnick, Director of Research at Ritholtz Wealth Management, posted a fantastic chart online a few days ago, and my phone lit up like a Disney fireworks show.

Phil: “Sorry, we’ve got to get home earlier than expected”

V: “Ok, sure, it must be something important”

Phil: “I have to tweet and blog about company weights within the S&P 500”

V: “…”

Here is the chart that Mike posted:

Click chart to enlarge

The chart shows the relative weights of the top five companies in the S&P 500, alongside the bottom 282 on the left hand side. Some have quibbled that the chart doesn’t show the middle 213 stocks, which is a fair point, but that was fully disclosed and anyway not related to what Mike was showing. The key point here is that investors in a market cap weighted S&P 500 index fund have as much exposure to just five companies as they do to the smaller 282 companies combined.

The graphic struck a chord and went viral, as it should have. It had a specific relevance to me, since we launched the Reverse Cap Weighted U.S. Large Cap Index (index ticker: Reverse), which allocates to the exact same stocks as any traditional S&P 500 fund, but the exact opposite concept. In a reverse strategy, those five goliaths are the smallest weighted companies.

There are three key reasons why we launched the reverse strategy. The first is that by weighting smallest-to-largest, Reverse captures the size premium, or “small minus big” within large cap. By keeping the size bet in the large cap space, we believe that the quality, liquidity and valuation issues that have called the size premium into question are largely solved.

The second reason is that when we rebalance reverse, we take profits from the winners and reallocate that money to the stocks with the most room to run. It is a systematic buy-low-sell-high process that contributes outperformance in all but extreme-momentum cycles.

And the third, the one that I want to focus on here, is that a reverse index can be used as a tool alongside a market cap weighted S&P 500 index fund to flatten the distribution of the stocks. It is for this reason that Mike’s graphic was sent to me by a dozen clients, friends, and coworkers. We have been trying to highlight the concentration risk in market cap weighted funds for a long time, something Mike just did in a powerful way.

I recently posted a gif image here on Twitter showing how adding a reverse strategy along side an allocation to the S&P can drastically reduce portfolio concentration. As gif images aren’t supported everywhere, Ill use a couple of the source graphs below. Along the vertical axis are the company weights, and horizontal are the companies, largest to smallest as left-to-right. SPX (S&P 500 Index) & Reverse index relative weights are labeled on top. HHI stands for the Herfindahl-Hirschman index, measure of index concentration calculated by squaring the weights of each constituent, and then summing the resulting numbers. The lower the HHI the better the diversification.

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