Is a Cap-Weighted Index Fund Diversified?

Advocates of active management – particularly those who favor smart-beta strategies – claim that cap-weighting suffers from the irreparable flaw of overweighting a handful of supposedly overvalued high-tech stocks. But that reasoning is flawed.

Diversification is the biggest “free lunch” in investing. Modern portfolio theory (MPT) proves a handful of stocks is riskier than the entire market. The risk of a single company is far greater than the risk of a handful of stocks. By owning more stocks, one decreases non-systematic risk, which is the risk the stock will perform worse (or better) than the market overall (also known as idiosyncratic risk). If we own the market, we have eliminated non-systematic risk and are left only with systematic risk. Systematic risk, of course, is the risk of the overall stock market, which cannot be diversified away. The market alone is very risky. MPT uses mean-variance analysis, a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk.

Let’s examine diversification using the U.S. stock market as an example, though other asset classes such as international stock and bonds are also part of a diversified portfolio. The chart above illustrates how non-systematic risk is reduced by owning more stocks. The logical conclusion is that owning every stock eliminates non-systematic risk.

But what should the weighting be for each stock?

The Vanguard Total Stock Market ETF (VTI) has more assets than any other fund (if we include all share classes). It owns 3,994 stocks though slightly fewer companies, as some companies have more than one share class. On the surface, that is diversified. But critics claim that the cap-weighting methodology, buying very large amounts of a few companies, is flawed.

As of September 30, 2021, the top 10 companies (11 stocks as Alphabet has two share classes) comprise nearly 24% of the holdings.

Since 1996, the concentration is at a record high and nearly twice what it was then.