Indexing May Not Yield All The Diversification Benefits You Think

My friend, Ben Carlson, recently wrote a post that detailed some of the potential pitfalls of the major shift toward indexing.  He included in his list such items as the potential for weaker hands capitulating and blindly bidding up shares at perhaps an inopportune time, and also the fact that the success of indexing, while likely mitigating tax drag and minimizing fees, will still leave you very exposed to normal market ups and downs, not least because index funds tend to be more fully invested than actively managed equity mutual funds.

To build on Ben’s point, there is also the risk that index funds may leave investors less diversified than they think.  All too many investors hold the mistaken belief that diversification stops at owning a lot of stocks.  This is obviously false; after all, a pool of 30 energy stocks, in theory, should offer less diversification than a pool of 10 stocks from each of the major sectors of the market.

Given this, it is worth noting that the S&P 500, as currently constituted, does not offer investors as much diversification across sectors as it once did.  One way to visualize this is by comparing the performance of the S&P 500 with an index created by equal-weighting its ten major subindices (financials, energy, tech, and so on, rebalanced annually):

The reason the S&P 500 and the sector equal-weighted version tracked each so closely for most of the 1990s was that the sector composition was far more balanced for most of that decade, right up until the peak of the tech bubble in early 2000:

Since then, however, S&P 500 sectors with less correlation with the overall market such as utilities (roughly 42% correlation since 1990) and telecommunications (63%) have fallen to such an extent that each currently makes up less of the S&P 500 than Apple itself.

The S&P 500 index has become dominated by technology shares to such an extent that currently more than 9% of the S&P 500 index is composed of just four companies, each from the technology sector:  Apple (3.7%), Microsoft (2.5%), Facebook (1.65%), and Alphabet (1.25%).  This top-heavy concentration makes S&P 500 index holders especially vulnerable to setbacks in the technology sector; in fact, Charles Schwab’s Jeffrey Kleintop noted that since 2006, the broad US market has had very high correlation with global technology shares.

To illustrate further Mr. Kleintop’s observation, it is interesting to track the rolling 3-year correlations of the S&P 500 index with the S&P 500 Info. Technology subindex:

In fact, the correlation between the S&P 500 and its technology component has reached around 90% over this time frame.

There are good explanations for the success of tech companies and their growth within the S&P 500.  As The Economist wrote recently, the US market in general, and tech companies in particular, have benefited from a recent surge in the dollar.  But this success may come at a price to be paid later by unwary investors:  the consequent drop of exposure to utilities, telecom, and energy shares (also one of the least correlated subindices in the S&P 500), as well as an already pronounced home bias means that investors with the S&P 500 index as their only equity exposure are not nearly as diversified as prudence would dictate.

Disclosure:  The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Fortune Financial Advisors, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Fortune Financial Advisors, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.