Have the biggest mega-caps run too far?

John Feyerer, Senior Director of Equity ETF Product Strategy, Invesco.

In 2020, U.S. equity markets have taken a path that few could have seen coming. As a result, the S&P 500 Index has become more top-heavy than it’s been in 45 years. Below, I explain why this is the case, what it means for investors — and what they can do to help mitigate this concentration risk while maintaining exposure to the companies that make up this well-known benchmark.

The S&P 500 Index is dominated by just five holdings

Since its low on March 23, 2020, the S&P 500 Index has fully recovered on the back of historic government and central bank intervention.1 Not only has the index turned positive for the year, it has now exceeded its Feb. 19, 2020 high.

During this year’s equity roller coaster ride, the five largest holdings in the S&P 500 Index – Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Alphabet (GOOG/GOOGL) and Facebook (FB) have shined brightly. The average year-to-date return among these largest five holdings is more than 38%,1 driven by the perceived safety of owning the biggest companies as well the importance of technology and communication services in the work-at-home/stay-at-home world suddenly thrust upon us by the Great Lockdown.

Why is this outperformance by the mega caps important? Like many benchmark indexes, the S&P 500 uses market capitalization to weight securities. This means that despite the significant number of securities that are included, the risk and return of the index — and of the traditional index funds that track it — is driven by the largest holdings. The dominance of just a few large holdings on overall risk and return is called “concentration risk.”

The recent run up in these “biggest of the big” companies has created a situation in which the S&P 500 Index is more top-heavy than it has been in 45 years. As of Oct. 31, the top five stocks accounted for nearly 23% of the weight in the S&P 500 Index, up from 16.8% at the end of 2019 and widely surpassing the 16.6% observed in December 1999 (which was in the midst of the final build-up before the technology bubble burst in March 2000).3

Benchmark indexes face historic levels of concentration risk

As shown in the chart below, the current concentration risk of the S&P 500 is only a few percentage points from the high of 27.7% reached in 1964.2 This amount of concentration risk is one that traditional passive investors haven’t faced in over four decades. When concentration risk is the simple result of market capitalization (versus, for example, the intentional choices of an active manager), it may leave investors vulnerable in a few different scenarios: when valuations mean revert, when new competitors have a negative impact on the top companies, when regulatory risk emerges, and when the market experiences a rotation into more cyclical stocks.4

Concentration risk: The concentration in the top 5 holdings is nearly 23%, a level not seen since 1975

While the S&P 500 has enjoyed a healthy total return of 73.4% (11.6% annualized) since late October 2015, these five names had an average total return of 256% (27.5% annualized), nearly three times that of the

S&P 500 Index from Oct. 31, 2015 - Oct. 31, 2020.4 Their valuations have also expanded to the point that the average price/sales5 and price/earnings6 ratios for the top 5 are now 2x (7.53 vs. 2.45) and 2x (43.76 vs. 25.35) versus that of the S&P 500 benchmark, respectively, as of Oct. 31, 2020.

Date range: Oct. 31, 2015 to Oct. 31, 2020. Source: Bloomberg, L.P., as of Oct. 31, 2020. An investment cannot be made into an index. Past performance is no guarantee of future results. The above companies were selected for illustrative purposes only and are not intended to convey specific investment advice.

Against an ongoing backdrop of strength for these market giants, as evidenced by second-quarter earnings announcements, it is important for investors to remember that there are countless examples from financial history that tell us that the largest companies as measured by market capitalization do not maintain that lofty perch years into the future. As of today, the five largest companies in the S&P 500 have an aggregate weight that is higher than at any point since 1975, when the likes of IBM, Proctor & Gamble, Exxon Mobil, 3M, and General Electric were the biggest of the big.

Consider an equal-weight approach

Investors looking to diversify away from these top-heavy benchmarks while still maintaining exposure to their holdings may consider an equal-weight approach. Equal-weight strategies weight each of their holdings equally, so that overall performance cannot be dominated by a very small group of companies. So, using the example of the S&P 500, each of the 500 index companies would represent approximately 0.2% of the portfolio in an equal-weight strategy.

The Invesco S&P 500 Equal Weight Index ETF – CAD (EQL) may provide a potential solution for those investors that may want to diversify their portfolio to help mitigate this concentration risk while still maintaining exposure to the S&P 500.

Important information:

The companies mentioned in this document were selected for illustrative purposes only and are not intended to convey specific investment advice.

The opinions referenced above are those of John Feyerer as of Oct. 31, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. There are risks involved with investing in ETFs. Please read the prospectus for a complete description of risks relevant to the ETF. Ordinary brokerage commissions apply to purchases and sales of ETF units. Diversification does not guarantee a profit or eliminate the risk of loss.

Some ETFs seek to replicate, before fees and expenses, the performance of the applicable index, and are not actively managed. This means that the sub-advisor will not attempt to take defensive positions in declining markets and the ETF will continue to provide exposure to each of the securities in the index regardless of whether the financial condition of one or more issuers of securities in the index deteriorates. In contrast, if an ETF is actively managed, then the sub-advisor has discretion to adjust that ETF’s holdings in accordance with the ETF’s investment objectives and strategies. Investments focused in a particular industry or sector, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

Commissions, management fees and expenses may all be associated with investments in exchange-traded funds (ETFs). Unless otherwise indicated, rates of return for periods greater than one year are historical annual compound total returns including changes in unit value and reinvestment of all distributions, and do not take into account any brokerage commissions or income taxes payable by any unitholder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing. Copies are available from Invesco Canada Ltd. at www.invesco.caS&P®, S&P 500®, and S&P 500 Low Volatility Index® are registered trademarks of Standard & Poor’s Financial Services LLC and have been licensed for use by S&P Dow Jones Indices LLC and sublicensed for certain purposes by Invesco Canada Ltd.Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under licence.

Invesco Canada Ltd., 2020. Published November, 26, 2020

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