Index Fund Investors Might Not Be as Diversified as They Think

Investing in an S&P 500 index fund is one of the simplest ways to grow your money. The large-cap stock index is used as a barometer for the overall stock market, and many say an index fund will provide instant diversification.

But an S&P 500 index fund merely reflects the market. And the market is currently favoring big technology stocks like Apple and Microsoft, meaning S&P 500 index fund investors may currently find themselves overweight in technology stocks when that’s not what they were aiming for.

A very top-heavy index

As of mid-August, Apple’s weight in the S&P 500 index reached 7.4%. That’s the highest weighting of any single company in the index since 1980, when IBM and AT&T were battling to be the most valuable company in the world (with a whole bunch of energy companies close behind).

Microsoft, which has spent some time as the No. 1 company, is 6.0% of the index. The top five companies combined — Apple, Microsoft, Amazon, Tesla, and Alphabet — account for almost 23% of the S&P 500. That’s an unprecedented level of concentration for the index.

What’s more, at least four of those companies (and arguably all five) have exposure to the technology sector. Microsoft, Amazon, and Alphabet’s Google are the biggest public cloud computing providers. Apple, Microsoft, and Google are all heavily reliant on personal computing devices. Microsoft is a leading enterprise software provider.

That said, only Apple and Microsoft fall into the information technology sector. Amazon and Tesla are considered consumer discretionary, and Alphabet is a communications services company.

In total, information technology companies account for around 28% of the index.

Is it a bubble?

Twenty-eight percent of the index in tech is certainly a heavy concentration, especially when you consider big companies like Amazon and Alphabet aren’t included in that number.

In fact, it echoes the concentration of the index in tech stocks near the height of the dot-com bubble, or the concentration of energy stocks in 1980.

Tech stocks took the brunt of the losses in the market downturn during the first half of this year, but considering they still make up more than a quarter of the S&P 500, are we looking at more losses to come?

A key difference between today and the bubbles of 2000 and 1980 are valuations. Apple and Microsoft are two of the most profitable companies in history. Their valuations are much more reasonable than the prices the market put on unprofitable tech stocks in the late ’90s.

Apple, Microsoft, and Alphabet trade at price-to-earnings (P/E) ratios between 1.0 and 1.4 times that of the S&P 500. When Microsoft was one of the biggest names in the S&P 500 in 2000, its P/E ratio was more than 2.7 times the S&P 500 average.

It doesn’t look like we’re in another bubble, but that still doesn’t mean you’re diversified.

Lose your concentration

If you’re looking to own a diversified portfolio of stocks across all sectors and market caps, you’ll need to invest in something other than (or in addition to) an S&P 500 index fund.

There are several options. You might simply add exposure to more small-cap stocks by buying a small-cap index fund. Putting more of your portfolio into an index fund that excludes the biggest companies can help balance the weighting of the top companies held in the large-cap index.

You might also considering shifting your portfolio to an equal-weighted index fund, which allocates the same amount of the portfolio to every stock in the index.

That said, these strategies have lagged in recent years. After all, there’s a reason the S&P 500 is more concentrated among the top companies than it’s ever been: Those top businesses continue to outperform. But there’s no guarantee that trend will continue. If you’re seeking diversification, you may want to consider how much weight you want in big tech, and what your alternatives are.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Adam Levy has positions in Alphabet (C shares), Amazon, Apple, and Microsoft. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Microsoft, and Tesla. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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