Your S&P 500 Index Fund is NOT Diversified

Listen to Episode 13 on my Financial Breakaway Podcast

Okay so today’s topic is one I am quite passionate about as it actually starts to get to the root of my overall investment philosophy.  And what I mean by that is, when you go about building an investment portfolio there are basically two conflicting concepts of how to do that “indexing vs active management”.  Now, people get quite passionate about one way or the other and I’m here to say I do not like indexing!  Yes, I said it!  It doesn’t jive with me I don’t like it not for me no way… now you might be saying…duh you’re an advisor you obviously like active management better because it justifies your job.  However, I’m here to say that’s NOT actually the root of it; the truth is that people really don’t understand what INDEXING is and the risk they subject themselves to because of that.  And therefore it’s not for me.  So bear w/ me, I’ll explain my position here as we go.

At the end of the day without a doubt my biggest job is actually managing client’s investments.   Now to some people listening that is obvious but to other it might not be, as other big part of my job is the financial planning work that goes hand-in-hand in how the investments work in someone’s overall financial life with liquidity, tax, family, retirement, income needs, etc,…but the daily work of actually picking investments and building portfolios for clients is by-far the biggest responsibly I have.

 To get right into the meat of it here: Let’s talk about the SP 500 index.  

This is probably the most common reference to when someone is talking about “buying the US stock market” as the SP 500 is considered the best representation of the US economy as it’s made up of the 500 largest publicly listed companies.   You can’t invest directly in an index but rather you can buy an index fund / ETF (exchange traded fund is their technical term) that tries to mirror it.  So let’s say someone does go to buy an “SP 500 Index Fun” most of those people see the “the 500 companies part ” and think they are buying portions of the 500 largest companies in the US and therefore they’re diversified.  

 And I’m here to say that is FALSE! Yes, you have EXPOSURE to 500 companies, but that exposure is not proportionate and not proportionate by a long shot.  In fact, the top 5 companies in the SP 500 account for over 20+% of the index’s return or downfall…. And I’m using data from slickcharts.com/sp500 ran on 8/31/21 to find this info btw.  How is that?  This is because of how the index is actually calculated when it comes down to it.  It is what they call a market-capitalization-weighted index.  Or in English, it means that bigger companies have a bigger impact on the return of the SP 500.  Or to say it a different way..an SP 500 index fund rides or dies with a concentration of risk on a VERY Few number of stocks.

Now. Like I said earlier I HATE general indexing and this is why.  Its really not diversifying me like most people might think it is.  By just buying an sp500 index fun you really are just investing in the top couple of companies in the index with small exposure to some other companies.  BUT I LOVE index funds or their more appropriate name is ETF.  As there’s an ETF that tracks pretty much anything you want, any segment, or weighting of segments, etc.  And that is my investment philosophy using more of  these types of investments b/c I can customize a portfolio more to my desired risk vs reward tolerance.  And I can therefore try to get the best bang for portfolio risk, with more precision.   

Lets look at some numbers behind this on the SP 500

So I just mentioned that 5 companies in the SP 500 account for over 20+% of the index’s return or downfall…this is called “weight”.  Those five companies have over 20% of the index’s weight.  Those companies are Apple, Microsoft, Amazon, Facebook.  And I’m using data from slickcharts.com/sp500 ran on 8/31/21 to find this info by the way.  I’m going to share with you some numbers put out by AMG Funds…I’ll have the PDF link for download on my website (rhitch.com/resources) if you want to download it.  So what they did was they broke out some cool numbers in regards to these top companies in the SP500 and ran some scenarios to prove this point…specifically (Facebook amazon, apple, alphabet, Netflix and Microsoft)

 -from 12/31/14 – 6/30/21 faaang stocks annualized return was 35.07% vs the sp500 ex faaang 9.5 and sp500 14.21

 *this is the good side of the weighting system as those companies therefore are showing they produced a lot of the gains for the sp500.

 Again, I’m always saying know what you are invested in.  Obviously, these companies at the top weight of the S&P500 have driven most of its growth and have done very very well.  They are great companies but if you don’t know how they work then you don’t know what your risk level is at either.  

 Ok that’s it for me today, hopefully I gave you a lot to think about. Thanks again for reading and until next time…be well.