In this paper, we examine the relationship between index investing, concentration risk and the risk/return measurements of the Top 5 stocks held within the highly benchmarked market-cap weighted S&P 500.
Passive investing, synonymous with funds tracking market-cap weighted indices (in which companies receive an allocation relative to their size), has been on an excellent performance run over the last decade – with Large-Cap US Equity outperforming virtually every other asset class around the globe. This extended period of outperformance amidst relatively low volatility has attracted huge inflows from expert advisors and mom-and-pop retail investors alike, overwhelmingly to their benefit. However, this paper will explore certain underlying systemic risks to investors relying on market-cap weighted exposure in the current environment and highlight the importance of “knowing what you own”.
A main investor benefit of index funds is combining the diversification of owning many companies with the administrative simplicity of owning a single stock. Investors largely purchase the S&P 500 as an efficient way to participate across US Large-Cap Equities. However, as the largest companies in the index have continued to provide outsized returns, the S&P 500 has become more concentrated, potentially to the detriment of a diversified representation of US Large Cap – which many investors still believe it to be. Exhibit 1 is a chart of the Herfindahl-Hirshman Index (HHI) for the S&P 500, a widely respected measure of concentration within an industry. More simply speaking, this shows a measure of how highly concentrated the biggest companies in an index have become relative to the rest of the index, in this case the S&P 500. Data from 1979-2019 was sourced from a combination of S&P DJI and FactSet.
As seen above, the S&P 500’s HHI reading is at a recent peak, similar to those seen in 1999 and 2008. One reason behind this may be the record amounts of assets being pushed into index strategies that are all built on the same market-cap allocation philosophy. As dollars flow into market-cap weighted strategies, the constituents are pushed higher based on those passive capital flows, rather than the fundamental results of an increasingly profitable business. As the largest companies benefit most from market-cap weighted allocations, it also has the effect of attracting momentum based active and passive investors – at least partially contributing to a feedback loop driving an even larger allocations within the index itself.
The chart below provides historical context for how much weight the largest companies in the S&P 500 have accounted for over time. Data from 1979-2019 was sourced from a combination of S&P DJI and FactSet.
Exhibit 2 – Top 1, 2 & 5 company concentrations in S&P 500 (1979-2019)
While the current concentration within the top companies is not an historical outlier, it is easy to pick out similar in-sequence peaks occurring in in 1999 (pre Dot-Com bubble) and in 2008 (pre Great Financial Crisis). It is important to note there are many distinctions separating the current environment from the aforementioned bubbles, although each instance did contain a single sector which accounted for a disproportionately large weight within the S&P 500 (Tech and Financials, respectively).
Similarly, FAANG+M names – Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Google (GOOG) (GOOGL) and Microsoft (MSFT) have driven a disproportionate amount of the S&P 500’s return over the last 3-5 years and greatly contributed to the concentration uptick seen in the above graph. Although Exhibit 2 showed that the current level is not an outlier on an absolute basis, we do see differences in the sector complexion of these top holdings that may constitute an additional risk.
Exhibit 3 – Weighting & Sector Complexion of Top 5 S&P Companies
Even during periods of greater historical Top-5 concentration, we saw more diversification within the companies holding that mantle. The hegemony of the current leaders all representing the same sector (Info-Tech) may in itself constitute additional risk through raising the specter of anti-trust review. While the cap-weighted flows have certainly contributed to the size of these companies, it is also true that they represent extremely profitable businesses that have maintained growth rates and operating margins that even much smaller companies would envy. While we are highlighting the increased concentration risk of the current S&P complexion – make no mistake, these companies have earned their place at the top through years of providing valuable goods and services to consumers. However, as financial journalist Jason Zweig put so succinctly “trees can’t grow to the sky, because they would collapse under their own weight long before they got there”.
Notably, Exhibit 3 shows that every five-year period has resulted in at least one of the previous top five dropping out and often significant redistribution within the remaining companies. Investing is about judging expected future returns, while riding the momentum of previous winners is more akin to the below:
What can we learn from the historical forward returns of companies which have already reached the top of the heap? Consider the following results of both cap weight (Top5 CW) and equal weight (Top5 EW) portfolios consisting of the five largest companies over various time frames.
Exhibit 4 – Annualized Returns 1980-2019
A portfolio consisting of the five largest companies (either cap or equal weighted) emphatically underperformed the S&P 500 and the S&P 500 Equal Weight Index (SPEWI) across all examined rebalance periods during the last 40 years. However, returns are only one part of the equation – the argument can be made that these large blue-chip companies may compensate for a lower return, through providing lower volatility. Exhibit 5 shows the annualized standard deviations for the same set of portfolios
Exhibit 5 – Annualized Standard Deviations 1980-2019
Much like annualized return, the standard deviations of the different “Top 5” portfolios are less favorable (in this case higher) than those of the S&P 500 and S&P 500 Equal Weight as a whole. Not surprisingly, this risk/return relationship carries over into Sharpe Ratio.
Exhibit 6 – Sharp Ratios 1980-2019
What Does this Mean?
This analysis points to the fact that although companies gain size within the S&P based on relative outperformance, the above return streams indicate that those stocks do not necessarily sustain that outperformance in future years. Clearly, it is impossible to predict when performance will turn for any given company, but the nature of cap-weighted indices ensures that a company will reach its largest weight within a portfolio, just before that turn takes place. In that way, cap weighted indices are essentially systematizing “Buying High, Selling Low,” the upper tail of which is demonstrated in Exhibits 4-6 above.
The fact that the forward performance of the S&P 500 as a whole outperforms its largest holdings AND S&P 500 Equal Weight outperforms its cap-weighted counterpart shows that over the medium to long term, it is a much broader swath of companies that drive S&P performance. “Size” and “Value” factor premiums are at least partly responsible for the spectrum of increased returns as one goes from “Top 5” to cap-weight to equal weight.
Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link. Fama-French factor portfolios are from the Ken French Data Library.
Exhibit 7 illustrates this spectrum effect – showing that portfolios can target Size (SMB) and Value (HML) and Momentum (MOM) factor exposure through incrementally shifting weight from cap-weighted to equal weight and further to reverse cap-weight. This concept is further explored in this 2019 FTSE Russel research paper.
Opportunities to Address Investment Inefficiencies of Cap-Weighting
When viewed through the lens that cap-weighted indices systematically over-weight overvalued companies, it’s apparent that exploiting the allocation inefficiency of cap-weighting through equal weighting is only a half measure.
The opposite of “Cold” isn’t “Room Temperature,” it’s “Hot.”
The Reverse Cap Weighted Index (Reverse), which, as the name implies, reverses the order of the S&P 500 through weighting by 1/Mkt Cap, takes exploiting that inefficiency one step further. In direct contrast to cap-weighting, Reverse, by definition, systematically over-weights undervalued companies. More information on Reverse Cap Indexing can be found here. The net result of weighting a portfolio in this manner is effectively a contrarian play within the S&P 500, as the largest companies/industries in SPX would be the lowest weighted within the Reverse Index.
Historically, in environments in which SPEWI outperforms SPX, we would expect Reverse to outperform them both. Conversely, in environments where SPX outperforms SPEWI (as is the case over the last three years), we would expect Reverse to be the worst performing of the three. Below is a chart detailing the performance of the three indices from 12/31/1996 – 12/31/2019.
Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link. Risk & Return data sourced from Bloomberg. All figures represent Total Return of the indices.
Exhibit 8 demonstrates how even shifting weight within the very same 500 stock portfolio can lead to different risk/return outcomes and shows the consistent relationship between the three weighting structures (e.g. diversifying away from the current largest companies tends to increase both expected return with an accompanying increase in volatility).
While the top-heavy S&P 500 is not currently a historical outlier in terms of concentration, it is undeniably at a near-term peak – an environment that has a history of mean reversion. The mechanism by which that concentration is redistributed, is a period where the largest companies (which gained their size through sustained outperformance of market peers) are no longer the primary engine driving the markets higher (or else disproportionately responsible for pulling the market lower). In those environments, it is important for investors to understand what comprises the indices they consider to be representative of US Large Cap equity. Market-cap weighting is an incredibly operationally efficient way to invest but presents investment inefficiencies which may have an outsized impact on expected future returns, particularly following times of heightened concentration. In the last 40 years, there has been consistent turnover in the best/biggest companies and when this happens within the setting of a cap-weighted Index, that turnover has a disproportionate effect on performance. Remember, “Trees can’t grow to the sky, because they would collapse under their own weight long before they got there”.
Disclosure: I am/we are long RVRS, SPY, RSP. Business relationship disclosure: See above disclosure
Additional disclosure: The author is an employee of Exponential ETFs, the creator and owner of the Reverse Cap Weighted U.S. Large Cap Index (the “Index”). Exponential ETFs has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third-party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Exponential ETFs. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).
The Reverse Cap Weighted U.S. Large Cap Index (Reverse) is a rules-based reverse capitalization weighted index comprised of the 500 leading U.S.-listed companies as measured by their free-float market capitalization contained within the S&P 500 universe. The Index has an inception date of October 23, 2017, with a back tested time-series inception date of December 31, 1996. You cannot invest directly in an index.
The information provided in this article is for educational, illustrative and discussion purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy or sell, any securities or investment products sponsored or sub-advised by Exponential ETFs. Investments in securities, derivatives, commodities, futures, options and other financial instruments are risky and may not be an appropriate investment. No guarantee or representation can be made that an investment will generate profits or that an investment will not incur a total loss of invested capital. Furthermore, nothing herein is intended to imply that any investment strategies may be considered “conservative”, “safe”, “risk free” or “risk averse.”
Certain information contained herein has been obtained or derived from unaffiliated third-party sources believed by Exponential ETFs to be reliable. Neither Exponential ETFs nor any of its affiliates or representatives makes any representation or warranty, express or implied, as to the accuracy or completeness of the information contained herein. The S&P 500 Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. You cannot invest directly in an index.
The S&P 500 Equal-Weight Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance. You cannot invest directly in an index.
The Herfindahl index (also known as HHI, or sometimes HHI-score) is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them. Named after economists Orris C. Herfindahl and Albert O. Hirschman, it is an economic concept widely applied in competition law, antitrust and also technology management. It is defined as the sum of the squares of the market shares of the firms within the industry (sometimes limited to the 50 largest firms), where the market shares are expressed as fractions.
Past performance of an index is not a guarantee of future results, which may vary. The value of investments may go down as well as up and potential investors may not get back the amount originally invested. Performance figures contained herein contain both hypothetical and live returns; results, hypothetical or otherwise, are intended for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Inclusion of a security within an index is not a recommendation to buy, sell, or hold such security, nor is it considered to be investment advice. It is not possible to invest directly in an index.
The Index, strategy, and performance returns discussed are for informational purposes only and do not represent an offer to buy or sell a security and should not be construed as such.
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