• Today 25% of that index is concentrated in just the five largest stocks by market capitalization — and it is not the only top-heavy equity index. 
  • The significant outperformance of the five largest stocks has led to investors falling into the recency bias trap — believing what has happened recently is likely to continue forever — but given enough time though, market sentiment has always shifted and once high flying stocks are often relegated to underperforming.

Most investors, even those based outside the U.S., are quite familiar with the S&P 500 Index. The index represents 500 of the largest U.S. companies and is often used as a model for popular passive mutual funds that seek to mirror its performance. One of the reasons that it is often used as a model by passive investors is its perceived diversification. After all, how can an index with 500 stocks not be diversified? Of course, if that’s not diversified enough, investors can easily find indexes that include more U.S. companies. The Russell 1000 Index represents about 1,000 U.S. large and mid-cap stocks. Or there is the Russell 3000 Index which adds another 2,000 U.S. small companies to that list and represents about 98% of the investible U.S. equity market. Many investors, including SEI, believe it’s prudent to diversify equity holdings globally. Here, investors may look at the MSCI ACWI Index, which contains more than 3,000 constituents from 23 developed and 26 emerging markets. Now that is an index that is truly diversified, right?

Not as Diversified as You Think

While all of these indexes hold a diverse group of companies in a broad range of sectors, and across the globe in the case of the ACWI Index, they are also market capitalization weighted. The exact methodologies by which each index provider calculates company index weights varies somewhat, but invariably leads to the largest companies receiving the largest weights in the index. If we look at the S&P 500 Index in Exhibit 1 (download PDF for exhibits), we can see that historically the top five stocks make up about 12% of the index, rarely falling below 10% or rising above 15%. But in 2020, the top five companies are approaching 25% of the index’s market capitalization. Do you still think the S&P 500 is a well diversified index?

While the S&P 500 Index is the most glaring example of this extreme concentration in the top five holdings, it’s certainly not the only index that is extremely top heavy right now. Even though the Russell indexes add about 500 or 2,500 stocks to the equation, the recent numbers don’t change much in terms of top five concentration. Because of the market capitalization construction of these indexes, adding small and mid-cap stocks really doesn’t do much because their weights are small compared to the top five. One way to demonstrate this is to simply compare the market cap of Apple (the top holding for all the indexes we have referenced in this paper) to the Russell 2000 Index which is composed of the smallest 2,000 stocks in the Russell 3000 Index. As shown in Exhibit 2, Apple alone has a market cap that is nearly as large the market cap for those 2,000 small companies combined. If you had a spare $2 trillion or so to invest, would you rather buy all of Apple or all of the 2,000 small cap companies in the Russell 2000 Index? Before you answer, consider that Apple was once a small cap stock and which one of those investments would provide more diversification.

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  • Alphas source: Alpha source is a term used by SEI as part of our internal classification system to categorise and evaluate investment managers in order to build diversified fund portfolios. An alpha source is the investment approach taken by an active investment manager in an effort to generate excess returns. Another way to define an alpha source is that it is the inefficiency that an active investment manager seeks to exploit in order to add value.
  • Market Capitaliztion Weighted Index: A company’s market capitalization is calculated by multiplying the total shares outstanding by the share price. A market capitalization weighted index will include the entire market capitalization of all the index constituents, hence companies with larger market capitalizations will comprise a larger portion of the index.

Index Definitions 

  • MSCI ACWI: The MSCI ACWI Index is a market-capitalization-weighted index composed of over 2,000
  • companies, and is representative of the market structure of 48 developed and emerging-market
  • countries in North and South America, Europe, Africa and the Pacific Rim. The index is calculated with net
  • dividends reinvested in U.S. dollars. 
  • Russell 2000 Index: includes 2,000 small-cap U.S. equity names and is used to measure the activity of
  • the U.S. small-cap equity market. 
  • Russell 3000 Index: The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. 
  • S&P 500 Index: an unmanaged, market-weighted index that consists of 500 of the largest publicly-traded U.S. companies and is considered representative of the broad U.S. stock market. 

Legal Note

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. There is no guarantee any strategies discussed will be successful.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI
Investments Company (SEI).