The high level of concentration within the S&P 500 presents an interesting mix of advantages and disadvantages to investors.

As we near the end of earnings season, there is one big name left to report, NVIDIA (NVDA). NVDA makes up about 8% of the S&P 500 Index which makes it the largest in the (SPX) by a full percentage point. Apple (AAPL) is the second-largest name in the S&P 500 at nearly 7%. Whether it’s earnings season or not, the high level of concentration within the S&P 500 presents an interesting mix of advantages and disadvantages to investors. On one hand, outperforming the index is difficult and traditional asset allocation foundations like diversification are causing portfolios to lag. On the other hand, the market has been doing so well, and most clients are likely in large cap equities for a significant portion of their portfolios, which has likely left them happy. Even as some of these companies are trading at lofty valuations, there hasn’t been much evidence that the trend is going to reverse anytime soon. As we see in the image below, the weighting of the top ten companies in the S&P 500 has more than doubled since the end of 2016 and is now above 40%. Other than 2022, the weight of the top ten stocks in the S&P 500 has increased every year since 2016. The largest stock in the S&P 500 in 2016 was AAPL with a 3.19% weighting, today NVDA makes up 7.99%. No matter how one looks at it, the market is heavily dependent on just a few companies, for better or for worse.

Perhaps the most important factor that can keep this trend of market cap dominance continuing are consistent flows into ETFs and mutual funds whose most dominant players are typically large cap cap-weighted type indices either directly or indirectly tied to the S&P 500. The graph below adds a data point tracking the annual flows into the top 20 US Equity ETFs by AUM (based on today’s AUM). We can see it tracks quite well with the weight of the top ten stocks in the S&P 500. These flows into mostly passive cap-weighted index tracking ETFs means that more and more dollars are shoved into the largest stocks regardless of valuation. As long as these stocks do well, especially relative to other stocks, they are getting more inflows which act as a strong force for further outperformance, and the cycle continues. Supply and demand remain king in a flow driven market. A secondary point, this is just looking at ETF flows, the overall flow number is likely much larger if one accounts for 401k and other retirement plans flows into mutual funds within defined contribution plans.

Looking to the future, it’s difficult to know when these flows slow down or even reverse. For now, the trend in price and flow is positive. Within this framework and top-heavy market, it does leave indices vulnerable to rapid declines and lackluster liquidity in stressful times until the long-term flows begin to stabilize the market. This mechanic does match some of the market events we’ve experienced over the last decade where we’ve seen rapid declines only to quickly rally back to new all-time highs. How we deal with this market environment is an open question. Staying with the trend is what we do at Nasdaq Dorsey Wright and it’s clear that the trend is positive for domestic equities, particularly the cap-weighted indices. However, the rapid declines and recoveries we’ve experienced over the last few years pose a problem from a risk management perspective. Having more “dry powder” to implement on actionable dips could be one way to play the situation. Diversifying into other asset classes is one way to reduce risk, but at the same time less of the portfolio is participating in the strongest part of the market. In any case, this is an important talking point with clients to remember what their financial goals are in the long run. While growing account values is great and a big part of what you do, clients’ primary goals are likely to be other things like feeling secure in retirement, passing along resources to their children and grandchildren, supporting chartable causes, etc. Maximizing returns is tantalizing, particularly in such a strong market, but risk-management to achieving financial goals is where you can separate yourself from other advisors.