Thanks to the success of the FAANG stocks — Meta Platforms Inc (FB), Alphabet Inc (GOOG), Amazon.com Inc (AMZN), Netflix Inc (NFLX), and Apple Inc (AAPL) — and other heavy-hitters such as Microsoft (NASDAQ:MSFT) and Tesla (NASDAQ:TSLA), the S&P 500’s concentration of returns was, well, concentrated in recent years.
In plain English, a small number of stocks accounted for a large percentage of a supposedly broad market index’s returns. That’s fine when things are working and those names don’t encounter company-specific headwinds. However, if one or two of the biggest names in the cap-weighted S&P 500 get hit, that bad news can reverberate throughout the entire index.
Such a scenario highlights the benefits of equal-weight exchange traded funds like the Invesco S&P 500 Equal Weight ETF (RSP).
“During 2020, the concentration of stock market returns reached a peak amid the pandemic-induced volatility,” according to Morningstar. “But the trend in 2021 has shifted toward a lesser degree of concentration of returns. For investors, this is a potentially healthier dynamic, with less risk for index-tracking funds and more opportunities for stock-pickers.”
Sure, it’s a positive that the concentration of returns in the S&P 500 is ebbing a bit, but the fact is that the top three components in the cap-weighted S&P 500 (Apple, Microsoft, and Amazon) combine for over 17% of the benchmark’s weight. That’s heavy concentration. Conversely, RSP’s top 10 holdings combine for approximately 3% of RSP’s roster. That diminishes return concentration and concentration risk.
“The unwinding of concentration is good for investors and the health of the market,” says Dan Kemp, global chief investment officer at Morningstar Investment Management. “Concentrated portfolios tend to be less robust to a change in the economic environment and have further to fall in the event of unexpected headwinds due their lofty valuations.”
Still, the top five stocks in familiar cap-weighted broad market benchmarks are delivering above-average contributions to market returns this year. Add to that, most of those names aren’t inexpensive. Some are richly valued, potentially underscoring the value proposition offered by equal-weight strategies.
To that end, RSP allocates 37% of its weight to value stocks.
“Market concentration came to a peak in 2020 when the top five holdings alone contributed nearly 40% of the market’s return for the year. This year, the largest five stocks have been responsible for 8% of market return, while the largest 10 stocks contributed a total of 20%,” notes Morningstar.
Those data points could be signs that investors looking for true diversification might want to consider RSP.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.