Your S&P 500 Index Fund Has Higher Risk Than You May Think

What is an ETF or Exchange Traded Fund?

The shift to index-based products has been one of the most powerful investing trends over the last four decades. Since the late John Bogle, often called “the father of index investing,” formed the First Index Investment Trust in 1976 with $11 million, the now-named Vanguard S&P 500 Index Fund holds nearly $600 billion in assets. Across all products, nearly $4.6 trillion in investments are indexed to the S&P 500. This comprises almost 16% of the total value of the S&P 500 companies.

This straight-forward, almost simplistic strategy revolutionized the investment industry. It allows everyday investors (and many sophisticated professionals) to participate in lockstep with the stock market’s performance, beating most actively managed portfolios yet with near-zero expenses. Even Warren Buffett himself, the dean of active investing, endorsed index funds as “sensible.”

On the surface, the S&P 500 does look like a sensible, diversified portfolio. It holds 500 stocks (actually 505), spread across 11 unique sectors – seemingly the very definition of “diversified.” And, over most of its history the index did offer a broadly diversified portfolio that generally represented the U.S. economy.

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Today this is no longer true. The S&P 500 index has evolved into an un-diversified portfolio concentrated on expensive, momentum-driven technology companies. Many investors, professional and retail alike, don’t appreciate this significant change, hiding considerable risk.

Currently, the S&P 500’s top five stocks, Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB) and Alphabet (GOOG), comprise 22% of its value – one of the highest levels of concentration since Bogle created the index fund 46 years ago. And, at the other end, the bottom two-thirds of the roster (330 stocks) comprise in total only 18%, suggesting that they contribute very little to investment diversification.

All of the top five companies are technology companies – not exactly the picture of diversification. Further weakening its diversification, technology stocks, including the ones mentioned above, comprise a combined 39% weight of the total S&P 500. For perspective, the combined weights of seven other sectors, Healthcare, Industrials, Consumer Staples, Utilities, Energy, Real Estate and Materials, add up to about what the technology companies are worth alone.

We include Amazon, Facebook and others in our technology group, even if they are formally assigned to other sectors by S&P Global, the company overseeing the index. About two years ago, these and other tech companies were reclassified into non-technology sectors to improve the appearance, if not the reality, of diversification. For example, Amazon is listed with the Consumer Discretionary stocks, but nearly all of its $1.6 trillion market value is driven by its Amazon Web Services cloud storage segment.

If a professional portfolio had 22% of its assets in major banks, or 39% in energy companies, it would be relegated to the “high-risk” pile and considered not fit to be the primary portfolio for mainstream investors.

Expensive? On traditional measures like the price/earnings ratio, the top five stocks trade at an average multiple on 2021 earnings of 36.5x. Yes, their fundamentals are better than that of the average S&P 500 company, but this multiple is nearly twice the median 19.3x of the other 495 stocks.

Momentum-driven? The top five stocks have gained an average of 40% this year, much stronger than the 7% return of the S&P 500 and the -3% loss for the average stock in the index. Clearly, this select group of five mega-cap tech stocks is performing in a way that says they are very different from the index.

What Should an S&P 500 Index Fund Investor Do?

With unexpected risks hiding beneath the index’s surface, investors should look inside their portfolio to see how much they rely on the S&P 500. If the answer is “too much given its risk,” investors may want to pare back their S&P 500 index holdings, especially if they also separately hold any of the top five stocks. Another step is to add stocks that produce true diversification. For hands-on investors who want to pick their own stocks, look for names with more value-oriented traits, where the companies have reasonable valuations with healthy or improving fundamentals. These stocks are capable of retaining their value (and moving up) even if the S&P 500 falters. September’s market illustrates the merits of diversification: the top five stocks fell nearly 10%, while the “other 495” stocks slipped only about 2.3%.

Two advisories which I oversee, the Cabot Undervalued Stocks Advisor and the Cabot Turnaround Letter, focus on attractively valued stocks with healthy or improving fundamentals. These value stocks are decided not by an index-hugging selection; rather, they emphasize the “other 495” stocks, as well as many that are not widely considered by mainstream investors yet have real value.

When the “tried and true” S&P 500 index isn’t quite so “true” anymore, these stocks can help investors restore diversification, reduce their risk and boost their potential returns.

Bruce Kaser - Photo

Undervalued Stocks Expert Bruce Kaser

Bruce has more than 25 years of value investing experience, managing institutional portfolios, mutual funds, and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company. Now he is helping his Cabot Undervalued Stocks Advisor readers find those undervalued stocks that let you buy low and sell high!

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