The S&P 500 index has long been considered the gold standard of passive investing. It offers average returns at average risk, which might seem like a reasonable choice for most investors. But “average risk” today means something very different than it did five or ten years ago – and that’s exactly what you should be careful about.
The S&P 500 represents the 500 largest U.S. companies and provides a faithful picture of what drives the U.S. economy. But there’s a catch. The weight of individual companies depends on their market capitalization, which is influenced by investor demand. Over the years, technology companies, thanks to their rapid growth, have gained much greater weight in the index, significantly changing its structure.
While five years ago, the information technology sector made up 27.6% of the index, today it accounts for 34%. The financial sector has strengthened from 10.4% to 13.8%. On the other hand, traditionally defensive sectors have lost share. The healthcare sector was hit the hardest, with its weight falling from 13.5% to 8.8%. Real estate and consumer staples also lost some ground. In practice, this means that 69 technology companies – just 13.7% of the index – account for more than a third of its returns.
The impact of individual companies is even more striking. Today, Nvidia dominates the index with an 8.1% share, and the top ten companies – eight of them tech – together make up 38% of the index’s weight. Five years ago, it was only 24.8%.
Nvidia alone now has more influence on the index’s performance than the entire healthcare sector, or than services, real estate, and materials combined. This creates what is called concentration risk – an excessive dependence on a few companies. This year, meanwhile, markets have been highly volatile. Since the beginning of the year, the S&P 500 has already recorded 11 days with swings of more than 2%, making it the fourth most volatile year of the past decade.
Volatility, however, is not the same as risk. Despite the uncertainty and sudden swings, markets have performed quite well this year. Growth has gradually expanded beyond the “Magnificent Seven,” and the expected interest rate cuts could support sectors that have so far been held back by high rates.
There is a way to protect against this high concentration in the S&P 500. It’s called the S&P 500 Equal Weight index, where all companies have the same weight. Interestingly, both indexes have performed similarly this year. While the classic S&P 500 has risen 9.14%, its equally weighted counterpart has gained 6.75%. In practice, investors are essentially “paying” 2.39% for reducing concentration risk.
What do you think? Are you hedging the S&P 500’s tech exposure? Let me know by tagging me as @thedividendfund on eToro!
