Is the main US stock market index too reliant on just a handful of companies?

Even though US stock indices hold hundreds of names, your diversification may be less than you think because of how companies are weighted in the index.

They are weighted by the value of each stock – so various companies worth trillions of dollars will account for a much bigger chunk of the index than those worth low billions of dollars.

This year’s market wobble has raised the alarm for some investors, who worry that their investments are at the mercy of just a few stock prices.

For example, just over one third (36%) of the S&P 500 by weight is represented by just nine stocks, despite the index including just around 500, according to AJ Bell research.

In times where those top stocks are doing well, this can turn the index into a boom town. But when they take a tumble, the effect can magnify the drop in performance for a tracker fund following the S&P 500.

What is an equal-weight index?

There is an alternative way to get US exposure, and one that spreads out the risks evenly – namely, an equal-weight version of an S&P 500 tracker fund.

An equal-weight index invests in the same companies as the regular version of the respective index, but each member accounts for the same slice of the pie, with the index rebalanced once a quarter. That stops the biggest companies by market value dominating the index’s performance.

For example, if you invested in a fund following the S&P 500 equal-weight index, you would have an exposure of about 0.2% in each company in the S&P 500. The top nine stocks in the S&P 500 that current dominate the market-cap version of the index (36% in aggregate) would account for just 1.8% of the equal-weight version of the index in total.

This creates a much more diversified investment. It can also have the benefit of making your investments more value driven than a regular index would be. This is because the index is constantly having to rebalance.

The downside is that an equal weighted version of the S&P 500 means you would have greater exposure to smaller companies than the market cap weighted version, which makes it a higher risk investment. Small cap shares are generally more volatile than larger companies, and they can be less mature businesses which adds another layer of unpredictability.

Which index will grow my money more?

Over the past 20 years, the S&P 500 market cap weighted index has generated a 555% total return versus 507% from the equal-weight version, according to data from FE Fundinfo.

The gap is even larger when looking at 10-year data, with the market-cap version returning 223% versus 149% from the equal-weight version.

That might suggest the eight-weighted version is inferior. However, there’s no way to know how any index will perform in the future. It all boils down to how you feel about concentration.

If you feel uncomfortable about a handful of stocks doing all the heavy lifting in the S&P 500 index – or any other major index – then an equal-weighted version is an alternative route to consider.

From Magnificent Seven to Nifty Nine?

The S&P 500 has evolved in recent years, with the so-called Magnificent Seven group of companies generating the bulk of the market returns. These are Google-owner Alphabet, retailer and cloud computing provider Amazon, iPhone maker Apple, social media network group Meta, software giant Microsoft, semiconductor specialist Nvidia and electric vehicle provider Tesla.

This dynamic is evolving. Two more stocks are now in the top tier of companies worth more than $1 trillion in the S&P 500, being semiconductor group Broadcom and Warren Buffett’s investment company, Berkshire Hathaway. That makes the index less reliant on a handful of names, albeit the issue of concentration is still prominent.

Fundamentally, the US index is now far more sensitive to the movements of top companies than 20 years ago. This means times of volatility have the potential to be even more up and down and extremes can come about more easily.

Equal weighting lays out the opportunity to mitigate that risk. And you don’t have to choose either or. You could split your investment between the two methods. This is the decision that AJ Bell’s investment team has made in its curated portfolios. By having a foot in each camp, you can still enjoy the gains while not having to hold your breath as much in the tumbles.