Are You at Risk of Concentrated Returns?

Despite turbulence, the S&P 500 Index is on track to post a healthy double-digit return in 2023. While this is generally considered a success, looking under the hood reveals that most of the S&P 500's return has been concentrated in just a few of the largest stocks.

The so-called "Magnificent Seven" (which is comprised of Alphabet (formerly Google), Amazon, Apple, Meta (formerly Facebook), Microsoft, Nvidia, and Tesla) is a collection of the largest and best-performing stocks in the U.S. These stocks have all skyrocketed in 2023 and contributed a big chunk of the return in the S&P 500 Index.

But what risks are associated with owning an index whose constituency is weighted towards these larger companies?

Constructing an Index

Investors typically purchase an index fund to gain exposure to various companies. However, when returns are concentrated in just a handful of companies, the diversification benefit investors receive from the index can be surprisingly small. Most indices are constructed using a market cap-weighted method of sizing constituents. Market cap-weighted indices assign weights to stocks based on the company's size, with larger companies carrying a higher weighting.

On the other hand, in an equal-weighted index, each stock is assigned the same weight, regardless of the company's size. Constructing the index this way provides more diversification but also gives smaller companies a disproportionately larger influence on the index.

Just How Concentrated Have Returns Been in 2023?

The S&P 500 Index is a quintessential market cap-weighted index and thus allocates a larger proportion to bigger companies. The Magnificent Seven stocks listed above comprise nearly 30% of the S&P 500. This is the largest degree of concentration for just seven companies since at least the 1960s, which means investors are getting less diversification than normal. To put this concentration into perspective, if an investor has $1 million invested in U.S. stocks through the S&P 500, their specific exposure to Apple and Microsoft would be over $70,000 each!

This unprecedented level of concentration is the result of outperformance. As of November 17th, the year-to-date performance for these seven companies ranges from a low of +26% (Apple) to a high of +220% (NVIDIA). These all surpassed the S&P 500's return of +16% and have contributed to over 80% of the index's return.

Comparing these returns to an equal-weighted S&P 500 index demonstrates the magnitude of the contribution from these companies. Under an equal-weighted methodology, each company comprises ~0.25% of the index, meaning that the Magnificent Seven would comprise less than 2% of the total index. When all companies are weighted equally, the return drops to a mere +2.5%, underperforming cash on the year!

Risks and Opportunities for Investors

For the same reason that the S&P 500 has benefited greatly from the Magnificent Seven's performance, it is also at risk of a pullback if strong positive sentiment for these companies does not continue. In the past, periods of high concentration were usually followed by a period of outperformance by a diversified equal-weighted index.

The previous two times that the concentration of the top seven companies in the S&P 500 peaked were 2008 and 2021. In 2008, the top seven companies in the S&P 500 peaked at just below 20% of the index. The following year, the S&P 500 returned +26% compared to the equal-weighted index returning +43%. More recently, the top seven companies peaked near 25% of the index in 2021. In 2022, the S&P 500 returned -18%, whereas the equal-weighted index returned -12%.

Summary

There is no guarantee that the concentration of companies within the S&P 500 has peaked or that an equal-weighted index will outperform next year. That being said, the diversification benefits of owning the S&P 500 are lower than in recent memory.

You may have invested more in Apple or Microsoft than you realized. For some people, this might not be concerning. For others, this concentration may be too risky. To determine what implications this may have on your portfolio, you should talk to a trusted financial advisor who understands your full financial picture.

About Us | Get the Bedel Blog | More Stocks Articles