Index Concentration and Hidden Risk

By Christian Gannon on July 17, 2023

Much has been written for decades about active and passive “index” investing. We do not hope to settle this debate with this post (or expect that it will ever be settled, but that’s another topic for another day). What we want to highlight is an overlooked aspect of index investing and that is concentration and control. The short version of this story is that, if you are an index investor currently, you are making a concentrated bet in a handful of highly valued, technology-oriented stocks. This may have more risk than you may expect or tolerate.

The chart above is provided by Visual Capitalist and gives a pictorial look at the concentration currently embedded in the S&P 500. Larger bubbles indicate larger weights in the index. The table below denotes the top 10 holdings as of June 30. These 10 holdings account for more than 30% of the index weight, and the top 5 are more than 22%. To put that into perspective, the weight of the top 10 S&P 500 index constituents five years ago was 21%. The top 5 holdings currently eclipse that figure. Additionally, you can notice a theme at the top of the list, the top 8 companies are almost all technology-oriented companies across a small handful of sectors. 

This is not to say that concentration is a bad thing, in fact, we believe that concentration can be useful and additive in thoughtful portfolio construction. However, when investing passively, you lose control to choose what you are concentrated in and to decide at what point you want to reduce that concentration.

The estimated P/E ratio for the S&P 500 is around 19x. As you can see below, the top 10 stocks have a P/E ratio of about 29x. The charts also show that the last time we’ve seen this kind of imbalance of P/E multiples was in the late 90s and that the earnings contribution of the top 10 has been shrinking over the past couple of years. Despite that shrinking earnings figure, the weight of those top 10 positions have grown to account for the largest proportion of market cap that we’ve seen in the last in the last 25+ years. 

In Howard Marks’ book, The Most Important Thing, there are two important concepts that he discusses that are germane to this discussion. One is that risk is difficult to quantify. Good outcomes do not denote low risk and bad outcomes do not necessarily denote high risk. We must consider risk at a point in time as the range of possible outcomes. Additionally, the true risk in investing is permanent loss of capital, not variance in portfolio value. A trap that we fall into as investors is using outcomes to judge the quality of our decisions. Index performance has been very good for the past decade, but as we know, past performance is no guarantee of future results. Risk management in index investing is out of the control of the individual investor. 

The chart below shows the number of managers that outperform over rolling 5-year periods. This chart goes back to the 1960s and the main thing to take from it is that, like most everything else in the investment industry, active investing tends to cycle in and out of favor relative to indices. We are also coming out of a prolonged period of manager underperformance. This isn’t the first time that less than 10% of managers have outperformed the S&P 500.  

A second point that Mr. Marks discusses is that the price we pay for our assets matters greatly and can be a key risk control. Paying too much for a good asset can lead to poor outcomes. Regardless of the quality of company or asset, buying at too high a price may be riskier than a lower quality asset bought at a bargain price. To be fair, Marks is a dedicated value investor, and we believe there are merits in other styles of investing as well. However, we do agree that regardless of style the price you pay matters and maintaining control over that can be very important in aligning goals and risk. Rather than spread every dollar across every company regardless of price, we prefer to add to positions with greater potential, hold positions that still look attractive but have realized some upside already, and pull from positions that have less upside. These are generally not all or nothing, in or out decisions, but shifts over time to meet your investing objectives while balancing risk and reward

When thinking about risk management and concentration, there is a difference between being concentrated in a diversified set of ideas that are lowly correlated and having concentration in positions that could be more highly correlated. Index investing takes that control out of your hands. You may have more risk in your portfolio than you think. 

Christian Gannon – Director of Investments | cgannon@twickenhamadvisors.com

Disclaimer

Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.