Boston - A few months back, we discussed alarming levels of concentration in the US equity markets and the uneven return participation of stocks after the market trough in mid-March. Many of these trends have accelerated since then — serving as a reminder of the market's growing fragility and the importance of diversification.
Anatomy of a cap-weighted index
The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. To be included, companies must have an unadjusted market cap of $8.2 billion or greater. According to index provider S&P Global, over $9.9 trillion in assets are now indexed or benchmarked to the S&P 500, with indexed assets comprising approximately $3.4 trillion of this total.
Unlike the name suggests, the index actually includes 505 leading companies and covers approximately 80% of the available US market capitalization. According to Ned Davis Research (NDR) as of August 31, 2020, the top five positions in the S&P 500 account for 24% of the index's total market cap — the highest share since the early 1970s and 60% higher than the 48-year average.
S&P 500 historical concentration of top five stocksSource: Ned Davis Research from January 31, 1972 to August 31, 2020.
The S&P 500 Index is rebalanced on a quarterly basis. By contrast, the Russell family of indexes, which are managed and administered by FTSE, rebalance annually in late June. Over $8 trillion in assets are benchmarked to the Russell US indexes, according to FTSE Russell data as of December 31, 2018. The Russell 1000 Index includes approximately 1,000 of the largest securities based on their market caps and represents over 90% of the US total capitalization.
Style indexes such as Russell 1000 Growth and Russell 1000 Value provide for additional flavors of the US large-cap investable universe. NDR reports that as of August 31, the top 5 and 10 issuers represent nearly 40% and 50%, respectively, of the Russell 1000 Growth Index — the highest concentrations in over two decades.
Passive buyers beware
With global assets held by exchange traded funds reaching $7 trillion,1 we estimate that a majority of assets are now invested in passively managed products. Recent leadership in the largest index positions could possibly remain. But at this juncture, we believe the situation presents concentration risk with no return or valuation advantage.
As an example, every $1 passively invested in an S&P 500 index tracker would allocate roughly 25% to just five companies. On average, these companies have already outperformed the S&P 500 by more than 60% over the past year and now trade at a 90% premium to the market — and at least a 110% premium to the median company in the S&P 500.
Weights, returns and multiples across US large-cap indexesSource: FactSet, Eaton Vance data as of August 31, 2020. Top 5 & Top 10 refer to the largest index constituents by market cap, grouped by issuer. Average 1 year return is the average of those constituents' returns over the year ended August 31. Past performance is not a reliable indicator of future results.
Bottom line: Such narrow leadership has ushered in an era we called the Great Concentration back in June. Just a few companies account for an outsized weight of the market's total capitalization — and thus many of the benchmark indexes they constitute. In our view, this new normal underscores the value of active management, which can help a portfolio avoid the unintended risk from such unprecedented index concentration.
1 Financial Times, "ETF assets reach $7tn milestone" by Chris Flood, September 9, 2020. https://www.ft.com/content/e59346a7-b872-4402-8943-2d9bdc979b08