Key Takeaways
- As a result of the growing security and sector concentration in the S&P 500 Index, investors in this index seeking diversified exposure to the domestic equity market now have disproportionate allocations to certain stocks and sectors.
- This can put their capital at risk should the overall market, or certain concentrated stock or sector positions, decline meaningfully in value, as has been the case in 2022.
- As an active manager, SBH has a proven history of selecting individual stocks to create diversified portfolios and of monitoring those portfolios over time to help ensure they remain diversified and aligned with investors’ long-term risk/return objectives.
Many investors choose to invest in passively managed index funds to gain broad exposure to various parts of the stock market. What they may not realize, however, is that the performance of these indices can be dominated by a handful of individual stocks and sectors—especially during certain time frames—as is the case with the S&P 500® Index. The S&P 500 is currently displaying some of the highest levels of individual security and sector concentration that we have seen over the past 20+ years. For investors in index and index-linked products, this may have significant implications for their risk objectives.
The S&P 500 is a cap-weighted index, meaning the stocks of the companies in the index with the largest market capitalizations will have an outsized impact on the return of the index compared to the stocks of smaller companies. When the largest companies are the best performers, which has generally been the case over the last 10 years (driven predominantly in this cycle by technology companies), index investors will tend to do better than active investors. Of course, as the larger companies continue to perform well, they can grow so large as to make the index extremely concentrated. While this can benefit investors when the index is rising, it puts their capital at risk when the index falls. The following charts show this concentration for the S&P 500 from both a company and sector perspective.
Company Concentration of the S&P 500 Index
5 Largest Companies in the S&P 500
Effective Number of Companies in S&P 500
Source: FactSet
The charts above tell two versions of the same story. The top chart shows the percentage the five largest companies (that is, 1% of the names in the index) have represented in the index over the past 20+ years. These companies, which include household names Alphabet (Google), Amazon, Apple, Microsoft, and Tesla, constitute 22.5% of the market cap of the index, near the highest percentage in the last 20 years. The bottom chart uses the Herfindahl Hirschman Index1 to gauge a similar version of concentration. The lower the value, the fewer the number of companies needed to represent the entire index. The current reading of 66 (out of a possible 500) is near the index’s 20 year low. Prior low points were reached during the Dot-Com bubble in 1999-2000 (at 77) and during the Great Financial Crisis of 2008-09 (at 99). As larger companies comprise more of the index, they crowd out the impact of smaller company performance on the index’s overall return.
Sector Concentration of the S&P 500 Index
Source: FactSet. Data for 2022 is as of 8/23.
While some sectors have remained relatively constant in their index weightings over time, others such as Information Technology and Financials have experienced periods of significant expansion or contraction over the past 20+ years. As evidenced in the chart, the sector weighting of Information Technology (IT) in the index, even after the sell-off that has occurred year-to-date in 2022, is currently at one of its highest levels in the past 20 years at 28%. These shifts in sector concentrations are often driven by larger macroeconomic forces, such as described in the examples that follow.2
Sector Concentration of the S&P 500: Historical Examples
The Dot-Com Bubble of the early 2000s was preceded by a period of large investments into Information Technology securities. Many IT companies of this era showed little long-term viability but garnered speculative interest due to market hysteria around development of the Internet. As a result, the sector boomed and grew to more than 30% of the S&P 500’s value. Once the bubble popped, companies fell and the sector was hit hard, bringing the entire index down with it. From its peak in March of 2000, to its low in October of 2002, the index declined nearly 50%, while the Information Technology sector declined in excess of 80%.
The Great Recession began to truly hurt markets in the fall of 2007. Leading up to this point, the Financials sector had grown to be the largest within the S&P 500. As the mortgage crisis began to unfold and the financial system experienced stress, the sector fell from its weight of roughly 22% in early 2007 to its low of roughly 10% in March 2009. During this period, the S&P 500 experienced losses of 50% as the Financials sector tumbled more than 80%. While the Financials sector made the largest contribution to this period of value destruction, its systemic nature caused spillage and brought many other sectors down with it.
As a result of the growing security and sector concentration in the S&P 500 Index, investors in this index seeking diversified exposure to the domestic equity market now have disproportionate allocations to certain stocks and sectors. This can put their capital at risk should the overall market, or certain concentrated stock or sector positions, decline meaningfully in value, as has been the case this year. Making matters worse, this concentration largely goes undiscussed by passive fund providers, particularly during up markets. When markets reverse or decline, however, this unintended concentration may negatively impact investors’ ability to achieve their long-term risk/return objectives. As an active manager, SBH has a proven history of selecting individual stocks to create diversified portfolios and of monitoring those portfolios over time to help ensure they remain diversified and aligned with investors’ long-term risk/return objectives.
To learn more about our approach to investing, please contact us at contactus@sbhic.com.
1 The Herfindahl Hirschman Index is a commonly accepted measure of industry concentration. It involves squaring constituent values to magnify their position amongst peers. The results allow for an interpretation as to how many companies comprise an industry, or in this context, an index.
2 The examples are provided as observations, rather than predictions, as to how current concentration levels might play out.
Last updated in September 2022. This information has been prepared solely for informational purposes and is not intended to provide or should not be relied upon for investment, accounting, legal, or tax advice. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to accuracy or completeness. These materials are subject to change, completion, or amendment from time to time without notice, and Segall Bryant & Hamill is not under any obligation to keep you advised of such changes. This document and its contents are proprietary to Segall Bryant & Hamill, and no part of this document or its subject matter should be reproduced, disseminated, or disclosed without the written consent of Segall Bryant & Hamill. Any unauthorized use is prohibited.