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Your S&P 500 Index Fund Has Higher Risk Than You May Think

Putting your money in an S&P 500 index fund has long been deemed a safe way to diversify. The problem is the S&P isn’t all that diversified anymore.

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The shift to index-based products has been one of the most powerful investing trends over the last four decades. Since the late John Bogle, often called “the father of index investing,” formed the First Index Investment Trust in 1976 with $11 million, the now-named Vanguard S&P 500 Index Fund holds $760 billion in assets. Across all products, $5 trillion in investments are indexed to the S&P 500. This comprises over 12% of the total value of the S&P 500 companies.

This straight-forward strategy revolutionized the investment industry. It allows everyday investors (and many sophisticated professionals) to participate in lockstep with the stock market’s performance, beating most actively managed portfolios yet with near-zero expenses. Even Warren Buffett himself, the dean of active investing, endorsed index funds as “sensible.”

On the surface, the S&P 500 looks like a sensible, diversified portfolio. It holds 500 stocks (actually 505), spread across 11 unique sectors – seemingly the very definition of “diversified.” And over most of its history the index offered a broadly diversified portfolio that generally represented the U.S. economy.

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Today, this is no longer true. The S&P 500 index fund has evolved into an un-diversified portfolio concentrated on expensive technology companies. Many investors, professional and retail alike, don’t appreciate the hidden but significant concentration, valuation and inflation risks.

Concentration risk comes from the hefty weighting in the Technology sector. Formally, this sector comprises 28% of the index. But when adding in the weight of technology stocks such as Amazon, Tesla and Alphabet that are assigned by S&P Global (the company that oversees the S&P 500) to other sectors, the true technology sector weight is 40%. This is not the picture of diversification. If a professional portfolio had 40% of its assets in a single sector, consultants would relegate it to the “high-risk” pile and consider it to be unfit as a core portfolio for mainstream investors.

And, illustrating the concentration risk, it takes the combined weight of the next six largest sectors (Consumer Discretionary, Healthcare, Communications Services, Industrials, Financials and Consumer Staples), excluding the reclassified tech stocks, to add up to what the technology companies alone are worth.

Furthermore, the five largest companies in the index – Microsoft, Apple, Amazon, Alphabet and Tesla – comprise 22% of its total value. This is one of the highest levels of concentration since Bogle created the index fund 45 years ago, and would by itself almost certainly place the S&P 500 into the “concentrated” group of higher-risk portfolios. A typical professional portfolio might have half that degree of concentration.

Seen from another perspective: It takes the bottom three-quarters of the index’s roster of companies (365 stocks) to match the weight of the five largest. This long list of stocks clearly contributes little to the index’s diversification.

Valuation risk is also elevated in the S&P 500. On traditional measures like the price/earnings ratio, the top five stocks trade at an average multiple on 2022 estimated earnings of 33.9x. True, their fundamentals are better than the average S&P 500 company, but this valuation is almost twice the median 17.6x multiple of the other 495 stocks.

Inflation risk appears high as well. This risk is related to the valuation risk. Valuations for technology stocks, and the steady flow of capital backing unicorns and other fast-growth companies, depend heavily on low interest rates. The effect on expensive and speculative technology stocks could be harsh.

What Should an S&P 500 Index Fund Investor Do?

With unexpected risks hiding beneath the index’s surface, investors should look inside their holdings to see how much they rely on the S&P 500. If the answer is “too much given its risk,” investors may want to pare back their S&P 500 index holdings, especially if they also separately hold any of the top five stocks. Another step is to add stocks that produce true diversification. For hands-on investors who want to pick their own stocks, look for names with more value-oriented traits, where the companies have reasonable valuations with healthy or improving fundamentals. These stocks are capable of retaining their value (and moving up) even if technology stocks falter.

Two strategies which I oversee, the Cabot Undervalued Stocks Advisor and the Cabot Turnaround Letter, focus exclusively on attractively valued stocks with healthy or improving fundamentals. These stocks are decided not an index-hugging selection; rather, they emphasize the “other 495” stocks, as well as many that are not widely considered by mainstream investors yet have real value.

When the “tried and true” S&P 500 index isn’t quite so “true” anymore, these stocks can help investors restore diversification, reduce their risk and boost their potential returns

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Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.