We have covered the issue of diversification many times this year in light of the extreme levels of concentration in US equities, where the top 10 stocks by market weight now account for a record 31% of the S&P 500 index.

This in turn means the US now makes up 63% of the MSCI All-Country World Index as of the end of October, so even investors who take a global approach are holding lots of US stocks and the top 10 in particular. 

As Duncan Lamont, head of strategic research at fund management group Schroders (SDR), puts it, global stock markets have become ‘top-heavy’.

‘This is clearly a problem for investors trying to build diversified portfolios as a significant proportion of their risk is being driven by a relatively small number of companies,’ says Lamont.

New research by Schroders shows that investors who passively track the US market tend to lose out in the years following high levels of index concentration.

‘Our research finds that, in the past, there has been a strong, statistically significant relationship between the degree of concentration in the S&P 500 and how the equal-weighted S&P 500 has performed relative to the S&P 500. The higher the concentration, the greater the outperformance of the equal-weighed S&P over the next five years.’

In other words, deviating from the market has been a winning strategy when concentration has been high.

As its name suggests, the equal-weighted S&P 500 index gives the same weight to all 500 stocks which means it underweights the biggest companies by market value and overweights the smallest.

The result is that when the biggest stocks in the index start to underperform, the equal-weighted index – which only has 2% exposure to the top 10 names in the cap-weighted index – races ahead.

Based on today’s 31% weight for the 10 largest stocks, this relationship suggests that the equal-weighted S&P 500 could outperform by more than 15% a year over the next five years, says Lamont.

‘This is a strong argument that the passive, market cap-weighted strategy favoured by many could struggle compared with others which have more freedom to deviate from such concentrated exposure.

‘Of course, this time may be different. However, even if the magnitude is up for debate, the broad conclusion appears robust: when the market has become very concentrated in a few stocks, investors have done better by allocating away from those stocks.’

Investors can track an S&P 500 equal-weighted index through iShares S&P 500 Equal Weight ETF (EWSP) and the Xtrackers S&P 500 Equal Weight ETF (XDWE), which are both quoted in sterling and carry a 0.2% ongoing charge.  

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