Indexes are generally a good way to diversify your holdings with one trade. For example, buying an S&P 500 Exchange Traded Fund (ETF) Index gives you exposure to all companies in the S&P 500 without having to buy 500 different stocks. Most indexes are market capitalization (the dollar value of a company calculated by share price times number of shares issued) weighted, which means the weight in the index is based on the relative value of a company’s market cap. Thus, an index of 4 stocks where Stock A has a market cap of $60B, Stock B has a market cap of $30B and stocks C & D have a market cap of $5B, would hold a 60% weight in Stock A, a 30% weight in Stock B and 5% weight in each of Stocks C & D. An investor buying this hypothetical index might think they are getting exposure to 4 stocks, when in fact they’re basically buying Stock A and a half position in Stock B. Stocks C & D will have little overall impact on the performance.
This is an extreme example but there are concentrations in many indexes. MSCI’s South Korean Index is 24% Samsung while the remaining 100 plus names are almost all under 3%. MSCI’s Taiwan Index is 23% Taiwan Semiconductor Manufacturing while the remaining 90 plus names are almost all under 3%. Larger countries such as Australia, France and Germany aren’t as extreme but have concentrations in their MSCI indexes. For the Australian, French and German indices, the top 3 holdings in each account for more than 30%, more than 25% and almost 30%, of their respective indices.
The U.S., with the largest stock market by capitalization, has some concentration but not to the same extent. Apple Inc (AAPL) and Microsoft (MSFT) are the two largest names in the S&P 500 at over 7%. Alphabet Inc (GOOGL & GOOG), Amazon.com Inc (AMZN) and NVIDIA Corp (NVDA) are all over 3% and all other names are less than 2%. The Russell 1000 Growth is more concentrated with over 12% AAPL and MSFT and over 5% GOOGL, GOOG, AMZN and NVDA, meaning the top 5 total more than 40%. See chart below.
When onboarding new clients, we’ll sometimes discover these “hidden” concentrations. Our software allows us to input funds such as Mutual Funds and ETFs and look-through to the underlying holdings to get the full picture of an investment portfolio. For example, a client may hold low-cost legacy positions of AAPL and MSFT at 15% each along with a S&P 500 ETF thinking that provides diversity. That account would be about 40% AAPL and MSFT and therefore not diversified, and so, riskier than it initially appears.
Concentrated indexes also need to be considered when analyzing performance. 2023 has been a strong year, with the S&P 500 up 11% through the end of October. However, the Equal Weighted S&P 500 (meaning positions are 0.2%) was down 2%. This means that the average stock has been down, and performance has been driven by the largest market capitalization stocks. This spread between the indexes is larger than normal and a reverse of last year, when the Equal Weighted Index outperformed by about 7%. Over the previous five years, the market cap weighted S&P 500 outperformed the Equal Weighted Index 3 times with both indexes having a compound annual return of about 9%. This suggests that a concentrated index adds risk while providing very similar returns.
A key part of Eagle Ridge’s onboarding process and ongoing management is identifying risks such as concentrated holdings. This analysis goes beyond seeing an index fund and assuming the account must be diversified. Once a concentration is identified, Eagle Ridge will determine the best plan going forward to reduce the risk, taking into account taxes and other considerations.