By Andy Willms, President & CEO
As of the market’s close today, the S&P is down roughly 1.5% for the year. That’s not too shabby, given that the index was down by over 30% back in March. But a deeper inspection of the index’s performance raises questions about the breadth of the S&P’s rally.
There are 505 stocks in the S&P 500 Index, but they are not treated equally. To the contrary, the S&P is a market-capitalization weighted index. That means that the larger the company, the larger the share of the index that is allocated to that company’s stock.
As of this writing, the five largest components of the index are Facebook, Apple, Amazon, Microsoft, and Alphabet (Google’s parent) – the so-called FAAMG stocks. These firms, respectively, constitute 2.2%, 5.9%, 4.9%, 6.2%, and 3.4% of the S&P 500 index. In other words, just 1% of the companies of the S&P 500 companies account for over 22.0% of the entire index. Moreover, four of these behemoths have market capitalizations in excess of $1 trillion.
In 2019, the FAAMG stocks accounted for roughly 92% percent of the total earnings growth generated by all of the companies in the S&P 500. Since the start of the 2020, the FAAMG equities are up by a weighted average of nearly 40.0%, while the rest of the pack is down by a weighted average of roughly 3.0%.
In short, the FAAMG portfolio has been carrying the rest of the S&P 500. While this has been a positive development for investors holding funds that track that index, the growing FAAMG influence on the index’s performance could trigger problems for investors down the road. Reasons include:
Strong performance by the FAAMG stocks can offset underperformance by the other 500 index members. Media coverage of the S&P’s strong performance can cause some investors to be over-confident on the state of the stock market as a whole. It can also lead investors to question sound investment strategies with regards to diversification vs. the S&P index.
As the FAAMG stocks become more expensive, the risk associated with investing in the S&P 500 silently grows, and the index’s expected future returns decline.
The increased concentration in the FAAMG stocks introduces specific risk into the index; that is, the risk that a major problem specific to one or more of the FAAMG members could weigh heavily on the index.
Earlier this year, Goldman Sachs pointed out that the S&P 500’s extremely narrow market breadth and mega-cap concentration is destined to fade. Goldman noted that historically the median length of such narrow market breadth is three months, while the longest period was 27 months, from 1998 to 2000. “Often, narrow rallies lead to large drawdowns as the handful of market leaders ultimately fail to generate enough fundamental earnings strength to justify elevated valuations and investor crowding,” Goldman said.
There are a variety of ways to hedge the risk presented by the increased concentration of the S&P 500.
The first is shifting some of the money currently invested in the S&P 500 into an ETF that tracks a larger segment U.S. stock market. Examples include Vanguard Total Stock Market Index Fund (VTSMX) and iShares Russell 3000 ETF (IWV).
A second choice: reallocate a share of your investment in the S&P 500 market-weighted index into a S&P 500 index fund that invests equally in all members of the index. The largest of these is the Invesco S&P 500 Equal Weight ETF (RSP).
Another possibility is to acquire insurance against a sharp decline in the index by investing in a protective put option contract.
It’s important to note that all of these alternatives would have underperformed the S&P 500 index over the last year. As a result, none of these ideas may appeal to a short-term investor. However, if you are a long-term investor, then managing immediate risks may take precedence over short-term performance.