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Is Your Diversifier Diverse?

By J. Keith Buchanan, CFA

One of the central tenets of responsible investing is diversification.  An investor is well-served to allocate capital across a broad array of opportunities so as to not depend on one or a few prospects for income, capital preservation, and growth, we have all been told.  Funds that replicate the most popular equity indexes with broad exposures across sectors, industries, factors, and themes should, in turn, provide prudent, responsible investing through diversification.  After all, the most popular stock indexes are intended to represent a diverse collection of equity securities.

However, recent market developments have left the indexes offering less diversification benefits than in years past.  The top ten stocks of the S&P 500 Index make up over a third of the index. This implies that market participants who are investing in funds that replicate the S&P 500 have more of their capital being allocated to fewer stocks than any time in recent past.  This is the opposite of diversification and an inherent risk associated with passive management.

This concentration is also reflected in the valuations for companies within the index.  The average stock in the index, represented by the S&P 500 Equal Weight Index, trades at a larger discount on a forward earnings basis than any time over the past 15 years. In essence, the market is attaching an increasingly large premium for the earnings of the largest companies in the index.

Source: Factset

Why does this concentration present a risk?  It does not present a standalone risk per se.  Just because a handful of stocks mean more to the earnings and valuation of the most followed indexes than normal doesn’t cause their downfall.  However, the dislocation makes the conditions ripe for risk to the entire index.  As the index consists of a few companies making up a larger proportion of the index and those same companies making up an even more disproportionate amount of the expected growth of the index, any reduction of earnings expectations from those highest valued companies has the potential to have an outsized impact on the index.  Furthermore, if there’s spillover to other larger companies due to a common theme, for example artificial intelligence, the impact could be magnified to an even greater extent.

Lack of diversification is a potential risk for any asset holder.  The lack of diversification embedded within the tools traditionally used for diversification is understandably even more problematic.  We view concentration risk as one of the primary dislocations in the investing landscape and remain diligent in assessing the potential effects as we enter the second half of 2024.

Source: FactSet

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