Broker Check

Concentration Risk in Today's Market

July 19, 2023

The broad-based rally of 2023 continued its march into the second quarter, with all major indices posting gains year-to-date. The tech heavy NASDAQ has led the way, with a 39.35% increase so far this year. While impressive, the NASDAQ has ground to cover to reverse its losses; the index is still 7.94% below its all-time high set in November 2022. Smaller U.S. firms, as represented by the Russell 2000, lag both larger domestic stocks as well as stocks in the international MSCI ACWI ex USA index. Inflation may show signs of cooling with the June year-over-year inflation numbers at 4.8%, below consensus estimates of 5%. The robust growth in the valuations of the largest technology firms coupled with the relatively slower growth of virtually all other U.S. companies has led to concerns about the market being dominated by only a select few stocks (concentration risk). In this newsletter, we will address concentration risk and explain CWAG’s approach to navigating this unique feature of today’s market.

On June 30th, 2023, Apple (AAPL) became the first company to reach a $3 trillion valuation. A consequence of this momentous rise is the fact that Apple now comprises roughly 7.5% of the entire S&P 500’s value, the highest share of an individual stock in that index since at least 1980. Other major tech names have also seen major gains so far this year. According to strategists at Bank of America Global Research, 7 tech stocks account for almost all the gains in the S&P 500 year-to-date: Apple, Microsoft (MSFT), Alphabet (GOOG, GOOGL), Amazon (AMZN), Nvidia (NVDA), Meta (META), and Tesla (TSLA). These stocks have experienced a comeback from their rout last year. The S&P 500's five largest companies (Apple, Microsoft, Amazon, Nvidia, and Alphabet, in that order) represent 22% of the index's value, so it is no surprise that as these stocks rise, they have an outsize pull on the rest of the index.

Per a May 2023 Invesco whitepaper entitled Four Reasons to Examine RSP, the top ten names of the S&P 500 accounted for 29.1% of the weight of the index at the end of April 2023. To put this in historical context, since 1980, the weight of the top ten companies in the S&P 500 has ranged between 17.5% and 30.5% based on year-end concentration numbers, so currently the market is towards the most concentrated end of the historical spectrum.

Other metrics illustrate just how concentrated the market capitalization is for the U.S. equities:

  • According to the previously mentioned Invesco whitepaper, at the end of Q1 2023, Apple and Microsoft, combined, had a market cap greater than the S&P 500 financial sector ($4.57 trillion to $4.43 trillion), and individually were worth more than the entire S&P 500 real estate, S&P 500 materials, and S&P 500 utilities sectors.
  • According to Yahoo Finance, Apple alone is now worth more than the entire small-cap Russell 2000 index.

While a select few stocks making up an outsized part of the market may intuitively appear concerning, it is important to point out that when these stocks perform well, they provide outsized returns to a market cap-oriented portfolio. In addition, there is a theoretical rationale behind allocating a portfolio based on market-cap: if the market deems a stock to have higher profit growth in the future, the value of that stock will rise. By pursuing a market-cap strategy, you are inherently allocating your portfolio by how profitable the market determines each stock to be in the future.

However, what fits nicely in a theoretical framework often does not work as intended in the real world. There are two key issues with blindly following a cap-weighted approach to equity investing: the empirical results and the psychology of investing.

The empirical results are quite telling. Looking at returns first, you will see in the Morningstar chart below that over long-time horizons, the S&P 500 Equal-Weight (in red) outperformed the market-cap weighted S&P 500 (in blue) going back to 2002, which is the earliest date that Morningstar had data on the S&P 500 Equal Weight index. The equal weight index returned an annualized 11.38%, while the cap-weighted index returned an annualized 10.39%.

In addition to returns being lower over the long run for the market-cap S&P 500 index relative to the S&P 500 Equal Weight index, their respective allocations have serious impacts on diversification as well. While the traditional S&P 500 index is often thought of as a balanced index, Invesco points out that “at the end of April, the overlap between the S&P 500 Growth Index and the S&P 500 Index was 66%.” By simply “riding the index”, you may be taking a bigger bet on growth stocks than you bargained for. Having an outsized position in any one sector reduces diversification and can lead to increased volatility in the portfolio.

“By simply “riding the index”, you may be taking a bigger bet on growth stocks than you bargained for.”

On the psychological front, having a concentrated portfolio can be distressing to investors. Even in good times, it is human nature to fear losses more than to be excited by gains. Therefore, when certain stocks in the portfolio outperform to a large degree, it is understandable that an investor may become concerned about how long this will continue before these high-flying stocks start experiencing losses and negatively impact the portfolio in an outsized way. By contrast, most people would be less concerned about the movement of any individual stock or group of stocks if each position made up a small part of the overall portfolio. What makes sense to us on a psychological level also applies as a fundamental axiom to investing- diversification can reduce risk in the portfolio.

While the S&P 500 Equal Weight index certainly looks appealing from a returns and diversification perspective, it is not without its own risks. Chief among these risks is volatility. By having each stock in the S&P 500 as an equal portion of the allocation, you would expect smaller and more volatile stocks to make up a bigger part of the portfolio than they would on a market-cap basis. This intuition is born out in historical performance statistics of the S&P 500 Equal Weight index. Over the past 10 years, this index has had a standard deviation (a measure of volatility) of 16.27%, compared to a standard deviation over the same time of 14.93% for the S&P 500. Therefore, simply equal- weighting your portfolio is no silver bullet; the tradeoff is increased volatility.

“Therefore, simple equal- weighting your portfolio is no silver bullet; the tradeoff is increased volatility.”

Compton Wealth Advisory Group takes a balanced approach between cap-weighting and equal-weighting our equity positions. If a market-cap weighted strategy is too biased to larger growth-oriented companies, so too is an equal-weight strategy too biased to smaller value-oriented companies. While we have focused on the potential risks in overweighting large growth companies, it is important to note that smaller companies have risks associated with them too and have underperformed the market recently. Therefore, our strategy broadly follows a market-weight strategy, but with the key difference being that we incorporate a balanced approach between value and growth stocks. Also, by rebalancing at strategic intervals, we ensure that no one position dominates the others. In this way, we strive to give our clients optimal exposure within the bounds of a market-weighted index, but with a more even representation of growth and value stocks than otherwise would be found in the S&P 500. While it can be concerning to hear about the dominance of just a select few stocks in the broader equity market, with the right portfolio construction, a more balanced allocation is indeed possible. We look forward to discussing this timely topic with our clients during our upcoming portfolio reviews.


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