The S&P 500 index has long been considered a staple in many portfolios, representing the U.S. market as a whole. However, a closer look reveals that the index is no longer as diversified as it once was. In fact, nearly 30% of its market capitalization is dominated by just seven technology giants.
While investors who hold a plain-vanilla S&P 500 index fund may be celebrating their gains this year, it’s important to recognize that these gains are largely driven by a handful of tech companies. Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Tesla, and Meta Platforms have been the driving forces behind the index’s performance.
According to Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, the S&P 500 can be seen as nothing more than a large-cap growth fund due to its reliance on market-cap weighting. This means that instead of providing exposure to a broad range of 500 companies, the index is heavily skewed towards these mega-cap tech stocks.
This concentration in the tech sector poses a significant risk, especially if there is another tech bubble fueled by artificial intelligence. Apple and Microsoft, the two largest holdings in the index, alone make up 14% of its total value.
Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, highlights the alarming trend of market performance being driven by a small number of companies with similar market cap, sector exposure, and valuations. This clustering of performance not only undermines the true purpose of diversification but also leaves investors with less diversified portfolios than they might have anticipated.
It is crucial for investors to be aware of the lack of diversification in the S&P 500 index and consider alternative strategies to mitigate concentration risk. As the market continues to evolve, a broader and more balanced approach to portfolio construction becomes increasingly essential.
The Concentration of Big Companies in the S&P 500
According to a recent report by FactSet, an astounding 50% of the expected S&P 500 earnings growth in the fourth quarter of 2023 will be generated by just four companies. These companies, namely Meta, Nvidia, Alphabet, and Amazon, are projected to contribute four percentage points out of the total estimated growth of 8.2%. Without their contributions, the S&P earnings growth for that period is anticipated to be only 4.2%.
It is not surprising that a small subset of prominent stocks tends to dominate the performance of the S&P 500. Dougal Williams, the chief wealth officer at Vista Capital Partners, which manages $2.2 billion in client assets, explains that historically, once these stocks become the largest in the index, their future returns often fall short of market expectations. Although their initial performance may be stellar, being at the top hinders their ability to outperform the broader market.
Fortunately, there are now more opportunities than ever to diversify beyond the S&P 500. Asset managers have responded to this need by introducing new strategies and offering low-cost versions of popular mutual funds through exchange-traded funds (ETFs).
Here are some key recommendations from investment strategists to take advantage of the market’s full potential return:
Invest Overseas for Enhanced Diversification
According to Peter Lazaroff, the Chief Investment Officer (CIO) of Plancorp, an investment company managing around $6 billion in client assets, international diversification is set to become increasingly crucial for investors over the next decade. In fact, Lazaroff suggests that it will be particularly significant in the next 12 months as well. Therefore, now is the ideal time to explore investment opportunities beyond domestic borders and consider allocating a portion of your portfolio to overseas markets.
By embracing these suggestions and diversifying their investments, investors can position themselves to maximize their returns and minimize their exposure to the potential risks associated with a concentrated market dominated by a few key players.
Smart Asset-Allocation Strategy: Adding Foreign-Stock Exposure
As a professional copywriter, I understand the importance of a smart asset-allocation strategy. One crucial element of this strategy is having exposure to foreign stocks, which not only diversifies your portfolio but also takes advantage of the current cheap valuations overseas.
According to Vanguard, international stocks present a good opportunity for U.S. investors to achieve higher relative returns. The drivers of U.S. stock outperformance over the past decade have likely sown the seeds for their underperformance in the coming years.
If you are looking to anchor your foreign-stock portfolio with ETFs, consider the foreign large-blend category. Additionally, boosting your exposure with small- and mid-cap European stock funds can be beneficial, as suggested by Morningstar.
Here are a few recommendations for ETFs in the foreign large-blend category:
- Dimensional International Core Equity Market ETF (DFAI): DFAI is an active ETF that offers exposure to the foreign large-blend category.
- iShares Core MSCI Total International Stock (IXUS): This passive ETF is another option for diversifying your portfolio internationally.
- Vanguard FTSE All-World ex-U.S. Index (VEU): VEU is a reliable choice for investors looking to broaden their international holdings.
- Vanguard Total International Stock Index (VXUS): Consider VXUS as another viable option for global diversification.
On the mutual fund side, Brandes International Small Cap Equity (BISAX) has shown stellar performance this year. With a total return of 19.3%, it has outperformed 98% of its category peers.
In conclusion, despite the tough year for value stocks, it is essential not to give up on value investing. While iShares S&P 500 Value (IVE) has seen an increase of about 11% this year, its growth equivalent, iShares S&P 500 Growth (IVW), has experienced a higher growth rate of 20%.
Value Stocks: A Steadier Approach to Investing
Victoria Greene, CIO of G Squared Private Wealth, a boutique firm managing around $560 million, believes that value stocks should still have a place in any investment portfolio. As markets show signs of mania, Greene looks for areas of the market that are more stable. These areas consist of higher-quality companies that offer a more defensive investment.
Exploring Different Options
To capitalize on this strategy, consider the following ETF options:
- iShares S&P 500 Value ETF: With an expense ratio of 0.18%, this ETF provides a good starting point.
- SPDR Portfolio S&P 500 Value (SPYV): For those looking for an even lower expense ratio, SPYV offers a rock-bottom expense ratio of just 0.04%.
- Vanguard S&P 500 Value (VOOV): VOOV comes with expenses of 0.1% and is another reliable choice.
- iShares Russell 1000 Value (IWD) and Vanguard Russell 1000 Value (VONV): These options have fees of 0.18% and 0.08% respectively.
Discovering Small Companies with Potential
Joseph Lazaroff from Plancorp suggests exploring small companies with promising prospects outside of the large-cap sector. Historically, winners and losers in asset classes go through cycles, and large-caps have been on top since the financial crisis of 2008-09. To potentially diversify your portfolio and capture growth opportunities, consider the Avantis U.S. Small-Cap Value (AVUV) ETF recommended by Lazaroff.
Highlighted Mutual Fund: Davenport Small Cap Focus
For those interested in mutual funds, the Morningstar four-star-rated Davenport Small Cap Focus (DSCPX) is worth considering. This fund has demonstrated a solid track record, outperforming 99% of its category peers over the past five years. In fact, this year alone, the fund has achieved a remarkable 12.5% return, outperforming 93% of its peers.
Remember, diversification is key in building a successful investment portfolio. While large-cap stocks have been performing well, it’s always prudent to consider value stocks and smaller companies with potential for growth. By investing strategically, you can minimize risks and maximize your chances for long-term success.
Diversifying Your Investment Portfolio
Setting the Right Benchmark
According to Ritholtz’s Carlson, one effective way to establish a benchmark for asset allocation is by finding a target-date retirement fund that aligns with your expected retirement date. By doing so, you can ensure that your portfolio remains well-diversified.
The Power of a Well-Diversified Portfolio
Using a target-date retirement fund as your benchmark provides you with a solid foundation for achieving diversification within your investment portfolio. It serves as a reliable guide to help you allocate your assets effectively.
The Path to Financial Success
Diversification is key when it comes to investing wisely. By following Carlson’s advice and utilizing a target-date retirement fund as your benchmark, you can feel more confident in your asset allocation strategy.
Leave a Reply