If I had £1 for every time I read that index funds are too heavily concentrated in big US tech stocks I would be a very rich man.
It is undeniably true. The FT recently reported that the top ten companies accounted for 37.3% of the S&P 500, which, by historical standards, is a very high proportion. Even more remarkably, just 26 stocks made up half the entire value of the index — the lowest number since at least 1980.
Several market commentators have warned that rising levels of concentration pose a threat. David Einhorn, founder of Greenlight Capital, for example, has described the markets as "fundamentally broken" and warned of "carnage" if the huge outflows of assets from active funds and into index funds we’ve seen in recent years continues. Chamath Palihapitiya, founder of Social Capital, has warned that ordinary investors in index ETFs are “in for a rude awakening if this isn’t addressed”.
Britain’s largest asset manager, LGIM, has also expressed concern that investors have become so reliant on the returns of a small number of stocks, particularly the largest US tech companies, the so-called "Magnificent Seven”.
Is concentration really such a problem?
But how worried should investors be about concentration?
A recent article by FT correspondent and Trillions author Robin Wigglesworth addresses that question. Wigglesworth believes that the US stock market is more concentrated now that an any other point in its 68-year history, and that a bursting of the tech bubble would have serious implications Even if that doesn’t happen, he says, current valuations for the Magnificent Seven suggest we could see lower returns in the future.
That said, he’s not overly concerned for three main reasons. First, history shows that, at any one time, a small proportion of stocks will almost always dominate returns; after all, research has shown that market returns have been driven by only around 4% of listed companies.
Secondly, several other countries, including the UK, France, Germany, India and China, have stock markets that are more heavily concentrated than the S&P 500.
Thirdly, Wigglesworth argues, “megastocks” like Alphabet, Meta, Apple and Microsoft are, in reality, “pretty diversified pseudo-conglomerates.” Brands like YouTube, WhatsApp, AWS, Instagram, Apple’s app store and Microsoft’s gaming division, he says, “would probably be worth hundreds of billions of dollars if they were standalone listed companies.”
The pot is calling the kettle black
But perhaps an even more important point to remember when considering this problem of over-concentration, if indeed it is a problem, is that it’s common to almost all funds — active funds as well as passive.
Jeffrey Ptak, Chief ratings Officer at Morningstar, recently conducted an experiment. He constructed a hypothetical composite fund by aggregating all active large-cap funds’ holdings each month, weighting each fund by its assets, and repeating each month. He then derived that composite’s monthly returns.
Those returns are illustrated in the blue graph (Investment A) in the chart below. The red graph (Investment B) shows the returns of an index fund. As you can see, the two funds performed in almost complete lockstep over the last 25 years. The returns of both are shown before fees and are almost identical; after fees, of course, Investment B (the index fund) would have comfortably outperformed Investment A (the actively managed composite).
Ptak writes: “Indexing critics claim… (that) investors pour money into index funds, the funds shovel those dollars into their top holdings, and the portfolio gets ever more concentrated… Were this the case, though, you’d expect active managers to stand their ground, avoiding the stocks sitting atop index funds in favour of others. And yet when you lump all active large-cap funds together it looks an awful lot like … the index.”
Ptak then looked at the top ten holdings in the S&P 500 as of the end of November 2024. What he found, as you can see from this second chart below, is that active funds, in aggregate, owned similar percentage stakes in these names to their index weightings. In other words, says Ptak, “the S&P’s concentration seems to closely resemble that of active investors as a whole.”
As Jeffrey Ptak points out, none of this is new. In his1991 paper The Arithmetic of Active Management, William Sharpe showed that, before fees, the average actively managed dollar must achieve the same return as the index. Why? Because the portfolios of active funds closely mirror the index. In essence, we are the index, and the index is us.
“That lesson,” he writes, “shouldn’t be lost on investors being warned that the S&P 500’s concentration in its top holdings represents a critical defect of cap-weighted indexing. If that makes indexing defective, what does it say about active funds, whose holdings aggregate to form the index’s weightings in the first place? Same today as it ever was.”
Conclusion
So, is the S&P 500 heavily concentrated by historical standards? Yes, although it’s no more concentrated than most other major stock markets around the world, and, in any case, markets have always been dominated by a minority of stocks.
Is concentration a reason for using actively managed funds? Absolutely not. In aggregate, active funds are just as heavily concentrated in big US tech stocks as index funds.
How concerned should investors be in general about the dominance of these stocks? Put it this way: the hugely impressive performance these companies have delivered since 2020 won’t last indefinitely. Should these stocks suddenly fall in value, it will hit the portfolios of both active and passive investors really quite hard.
As always, having a broadly diversified portfolio with exposure to multiple regions and sectors, and that doesn’t just include the biggest stocks, is the best approach.
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