S&P 500 Index Concentration Reaches New Highs – Strategically Navigating a Mega-Cap Dominated Market

The concentration of the S&P 500 is further exacerbated by the fact that all of the Mag Seven stocks are within the technology sector or have very “technology-like” characteristics. Therefore, not only is the S&P 500 becoming concentrated on an individual stock level, but the correlation of these Mag Seven index heavyweights is highly positive, meaning they tend to move together and poorly diversify each other when held together.

See below for a correlation matrix of the Mag Seven stocks, plus the Vanguard Information Technology ETF (VGT) for comparative purposes. Please note, VGT holds AAPL, NVDA, and MSFT, but not the other Mag Seven stocks.

The concentration challenge to advisors & asset managers

This presents a challenge to advisors and asset managers who may be trying to gain domestic large-cap stock exposure. However, they may also have diversification guidelines and have learned rules of thumb such as to not let a single position exceed 5% of a stock portfolio. Moreover, what if, based on their analysis, they like a megacap heavyweight such as Apple? Would it be prudent to overweight the stock from its 7.3% benchmark weighting to 10% or more of a portfolio?

As the chart above shows, large allocations to a single stock or collection of highly correlated stocks can disproportionately steer the returns of an entire portfolio, especially when the stock(s) in focus has/have experienced significant out- or underperformance versus the average equity. Thankfully, concentration has been investors’ friend over the last two years, as the outsized Mag Seven returns drove back-to-back yearly S&P 500 returns above 20%.

Differentiating between investment-centric and planning-centric advisors

I propose a few potential solutions to working with increasingly concentrated market indices. Before diving in, it is critical to understand the nature of your advisory/asset management business. Clients of “investment-centric” advisors typically focus on their portfolio’s total return and tend to evaluate their advisor versus a benchmark.

By having to be more “benchmark aware,” these types of advisors (depending upon how active they are in their portfolio management style) may be biased towards owning larger shares of Mag Seven positions in order to manage the potential for return differences versus a benchmark index.

By way of contrast, clients of more “planning-centric” advisors may pay some attention to performance versus a benchmark. However, more importance is placed upon hitting a client’s required rate of return derived from a financial plan or cash flow simulation. If this return target is being met, the performance difference versus any given benchmark or index, plus or minus, may be of less significance.

Regardless of the type of advisor, everything comes down to managing expectations. Most often, this is either communicated via a financial plan or an investment policy statement. These documents provide a place to “return home” when more popular and perhaps riskier and more concentrated strategies outperform. They can help keep clients and advisors on track and true to their investment processes.

Potential solutions to manage index concentration

Picking a globally diversified benchmark

Despite a global market of publicly traded stocks, many U.S.-based advisors still opt to populate equity portfolios with only domestic stocks. But if one selects a global equity benchmark, such as the MSCI All Country World Index (with its 67% U.S. weighting), the individual weightings of the Mag Seven stocks all fall to below 5%, and for the most part below 3%. Even choosing a benchmark allocation of 85% domestic stocks and 15% international stocks can dramatically reduce the company specific risk of an individual portfolio.

Beyond reducing concentration, allocating globally can also enhance overall portfolio diversification and expected risk-adjusted returns. Despite recent years of international underperformance, history shows us that geographic leadership is cyclical.

Moreover, most capital market assumption frameworks currently show international stocks as relatively undervalued versus U.S. large-caps and therefore having higher expected returns over the next decade. Of course, valuation is a poor short-term timing instrument. However, there are both diversification and valuation arguments to be made that advisors should consider a more global investment management framework.

Using an optimizer to diversify within sectors and indexes

Heads up: this section is fairly technical, but it explains one method to help reduce concentration within portfolios in a rules-based, quantitative fashion.

An optimizer allows us to “reconstruct” an index and place caps on individual positions. Then, one can optimize reconstructed portfolio weightings to minimize tracking error versus a sector or index.

In the simplified example below, I use Portfolio Visualizer to create a technology sleeve of a portfolio with maximum position sizes of roughly 12% of my overall technology sector allocation. Given that the technology sector makes up about a third of the S&P 500 index, a 12% sector allocation would correspond to roughly 4% of a total U.S. stock portfolio.

In the example, I list the top fifteen stocks in the Vanguard Information Technology ETF (VGT) to be included in the optimization. In practice, I would likely populate the optimizer with more individual names, using either VGT’s holdings or stocks from our internal buy list.

From here, we set minimum and maximum stock weightings. I use 3% as minimum weighting (which would correspond to 1% of a total U.S. equity portfolio) and 12% as a maximum (4% of a U.S. portfolio) for the Mag Seven. Other issues get a position cap of 8% (2.67% of a U.S. portfolio). I then tell the optimizer to adjust the portfolio so that it minimizes tracking error versus the technology sector over the last two years.

The resulting allocation gives a portfolio with a historical two-year return within 0.25% of VGT, a standard deviation within 0.10% of the fund, and a historical tracking error of 4.27%. The resulting allocation also reduces concentration of the megacap Mag Seven stocks within the technology sector (AAPL, MSFT, and NVDA).

The pros and cons of optimizing

One needs to be cognizant of the risks and potential changes in portfolio behavior when taking this approach to diversifying. First, optimizers use historical data to create portfolios with minimal tracking error. Just because Adobe and Microsoft moved with each other in 2023 doesn’t mean they will in future years. In part, this is good, as idiosyncratic risk is being reduced across a given portfolio. The goal here is to own more companies at non-concentrated weights in order to create a less volatile, better diversified investment strategy.

Consider, as well, that reducing allocations to the largest stocks will reduce the average market capitalization of a portfolio, thereby introducing a “size tilt” to the allocation. With this in mind, be careful not to over-allocate to separate small- and midcap funds. Finally, when combining the individual optimized sector sleeves, be aware of your sector allocations versus the index. I prefer to stay relatively sector neutral versus my allocation benchmarks.

Final thoughts: The key is managing expectations

This article has discussed two approaches to addressing the increasing concentration within the S&P 500 and other popular U.S. indices. Regardless of whether your personal solution involves large allocations to megacap Mag Seven stocks or diversifying more among stocks, styles, and geographies, communication and the setting of expectations are critical.

Every client, whether retail or professional, should have an investment policy statement or financial plan. These documents, if drafted and communicated correctly, should not only provide clear benchmarks for investment success for failure, but also strengthen advisor/client relationships, enhance trust, and provide a solid platform to guide both current and future investment decisions.

Christopher Diodato is the founder of WELLth Financial Planning.

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