One common difficulty for investors these days is striking the appropriate balance between individual stocks and ETFs in their portfolio.
In the Cabot Explorer, I embrace a “core and explore” strategy that relies on one or two ETF portfolios as the “core” holdings, which are then enhanced by individual stock picks that offer higher upside, the “explore” element.
Given the outperformance of a select few technology stocks this year, managing your “core” portfolio is more important than ever.
By looking “under the hood” of your ETF holdings, you can develop a better understanding of how stocks are weighted within each ETF and identify areas of outsized risk.
As an example, let’s consider the most basic ETF that tracks the S&P 500 (SPY).
Many investors hold SPY in their portfolios, thinking it is a low-risk way to track the market, and complement it with bonds and international stocks.
But most don’t realize that the S&P 500 index and, right now, SPY are riskier than you can imagine.
The reason is that the S&P 500 has become more highly concentrated in technology and financial stocks, more sensitive to interest rates, plus more correlated with other indexes around the world.
In short, the index has changed with the economy. In the 1970s, industrials and materials made up 26% of the S&P 500, but this has decreased over time and now stands just below 11%.
Meanwhile, tech and financials made up 13% of the S&P 500 in the 1970s before becoming the dominant sectors. Today, these two sectors make up 42% of the index by weight, with tech alone representing 29%.
In fact, six out of the top seven positions in the S&P 500 by weight are in the tech sector currently.
This Creates an Unexpected Risk for Most Investors
You may be tired of hearing that the S&P 500’s nice gain in 2024 is being driven by a handful of mega-cap tech stocks. The top 10 stocks now represent almost a staggering 37% of the index’s total value. That’s the highest concentration since September 2000.
This means that our largest risk in holding the S&P 500 index through SPY is the same as holding these tech stocks directly.
Furthermore, the expectations for earnings growth for these booming stocks are at a record high, and even a slight hiccup or delayed Fed interest rate cuts can crush valuations.
Therefore, the smart move right now to protect your portfolio might be to sell 25% of your SPY ETF and move the cash into Invesco’s S&P 500 Equal Weight ETF (RSP).
The 500 stocks in this S&P 500 Equal Weight ETF (RSP) basket are weighted equally, rather than weighted by market value. This translates on a sector basis to a more balanced 16% allocation to tech, 14% to industrial stocks, 13% to financials, 13% to healthcare, and 11% to consumer stocks.
The equal-weight S&P 500 ETF, RSP, has underperformed relative to SPY over the past few years, but since its inception, 21 years ago, RSP has produced a cumulative return of 542%, which compares to a 458% cumulative return over the same period for SPY, according to Morningstar.
On an annualized basis, RSP’s index, the S&P 500 Equal Weight Index, has generated an 11.5% gain since inception, which compares to a 10.8% annualized return for the S&P 500 Index over the same period.
The Cabot Explorer believes that making the best choices in picking the right combination of ETFs and stocks is critical to reaching your financial goals. This means building wealth and managing risk. It also means making smart moves to protect your portfolio. You can learn more about how we invest in Cabot Explorer at this link.