We hear sentiments like the title of our piece a lot. It’s a reasonable assumption, right? After all, it’s not the S&P 25. It’s 500 of the largest, listed companies in the country. And the weighting corresponds to company market capitalization so that it’s always the highest value companies, no matter what sector they are in. So diversification is built right in.
Let’s take a little walk through time and see how that theory holds up. Here’s a table of the largest five companies in the S&P 500 at 10-year intervals, beginning in 1970. The companies are not listed in any particular order.
|
1970 |
1980 |
1990 |
2000 |
2010 |
2020 |
|
IBM |
IBM |
IBM |
GE |
Exxon Mobil |
Apple |
|
AT&T |
AT&T |
Exxon |
Exxon Mobil |
Apple |
Microsoft |
|
GM |
Exxon |
GE |
Pfizer |
Microsoft |
Amazon |
|
Exxon |
Amoco |
Philip Morris |
Cisco |
GE |
Alphabet |
|
Eastman Kodak |
Schlumberger |
Royal Dutch |
Citigroup |
Chevron |
|
Source: S&P Dow Jones Indices LLC. Data as of March 4, 2020.
Looking at these names, the first thing that stands out is that there is a lot of sector concentration – and that it changes over time. The most diversified decade by GICs sectors was the 1970s, with Information Technology, Communications, Industrials, and Energy represented (Kodak is classified as IT). After that, it pretty much comes down to Energy and IT, with a couple of outliers.
Back in the day, that wasn’t necessarily a bad thing. Take 1990. Despite three companies in Energy being in the top five, the weighting of the sector as a whole, as a percentage of the entire index, was less than 15%.1 Consumer Staples, with just one company in the top five (Philip Morris – make of that what you will) actually had a slightly higher weighting in the index and clocked in at just 15%.2 No one sector was over 15% of the index, nor under about 5% of the index.3 So it does seem like there was some rationale for believing that tracking the S&P 500 could result in a fair amount of diversification.
Fast-forward to this decade. All five of the top names are in one sector – IT. No surprise there. But the weighting of the sector is now 28%. No other sector is even close or even half that weighting and a full four sectors are under 2%.4
What is that doing to your performance? When tech is up, it’s juicing your return. It’s also turbo-boosting your volatility. And this year, with inflation leaping up and the “great rotation” to value seemingly underway, that volatility may not be worth it anymore.
Does Passive Investing Have Hidden Costs?
Passive investing is touted as the low-cost way to achieve a diversified market return. We’ve seen that the diversification piece of that may not be all it’s cracked up to be. How about the “low cost”. In terms of efficiency ratio, no question. Passive investing is cheaper. Maybe that’s why as of 2019, there is more money invested in passive funds than in active funds in the United States. In one decade, passive funds went from $2 trillion to $11 trillion.5 And back to that market-cap weighted index, all that money is just getting allocated to the biggest companies, not necessarily the “best” companies from an active investor’s fundamental research point of view.
An interesting study co-authored by researchers at the University of Utah and the University of Kentucky looked at the hypothesis that passive investing may degrade market information, which could potentially alter prices and make business decisions harder.
The paper looked at commodity futures and found that when a commodity such as copper ends up on an index, businesses using the commodity see a 6 percent increase in costs and a 40 percent decrease in operating profits, relative to firms without commodity exposure.6
Eventually, that could turn into a vicious cycle in which the more investors put into markets, the more they drive down prices. Ok, so that’s not going to happen overnight. But it is worth thinking through an investment portfolio to be sure that you really are structuring your investments to achieve the goals you want – and doing that means avoiding as much risk as possible.