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Index Concentration Causes Investor Concern

Why does it happen, and what steps can you take?

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Christine Benz: Hi, I'm Christine Benz for Morningstar. Are major indexes getting more concentrated in their top holdings? Joining me to discuss that topic is Ben Johnson. He is Morningstar's global director of ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's talk about this topic. There's certainly been a lot of chatter about it. When you look across major indexes, are they in fact getting more concentrated in some of their top holdings?

Johnson: This has absolutely been the case, especially over recent months. And if you look at the S&P 500, for example, and its top five constituents, specifically Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Google (GOOG), those five companies alone account for 22% of the index's value right now, which obviously, is reflected in all of the various index funds and ETFs that are underpinned by the S&P 500.

Now, to put that in context, historically: 22% is incrementally higher than that was at the very peak of the technology bubble, where it reached about 16% or 17%. It is higher than it's been going all the way back to the early 1970s. So, many investors are seeing this and growing concerned.

Benz: How problematic is it? Is it a feature or a bug, as you put it?

Johnson: Well, when you think about market-capitalization weighting, it is definitionally a feature. It's what investors have signed up for. They've taken their hands off the wheel and said, "I am going to relinquish the allocations within this index portfolio to the wisdom of the crowds," but sometimes the crowds go a little bit mad. And honestly, we'll only know in hindsight whether this most recent spike in the concentration of the indexes is more attributable to wisdom or perhaps more so to madness. What index investors know for certain is that by sort of free-riding off of the collective wisdom or lack thereof of the markets, they are dialing down the cost of that portfolio, they are leveraging what over a long period of time has generally been more wise than mad, and ultimately, that has yielded over longer periods of time, a very good result for a very large number of investors. But it's important to understand that there have been episodes, which have often, like in the case of the tech bubble, been preceded by this degree of concentration, where for a number of years subsequently, indexing hasn't felt like that hot of an idea.

Benz: Let's discuss those risks because I think that's what investors who might own an S&P 500 index fund might be concerned about--that they are getting overexposed to a potentially overvalued pocket of the market. So, how should investors think about that?

Johnson: I think, first and foremost, it's important to acknowledge this fact, to acknowledge the fact that you're relinquishing the management effectively of the portfolio to the market at large and that there are pros and cons to taking that approach. So, I think the more investors can manage their own expectations, know that at least based on history, periods--again similar to what we're seeing today--have been followed by an unwinding of concentration, which generally has had negative effects on the market at large, because it's not just index funds, but really all funds and all investors that have a significant amount of capital invested in these very same names.

And what investors can do, I think, at the margin is maybe reconsider some of their allocations, maybe rebalance at the margin if they've got different funds that make up the equity sleeve of their portfolio, and they might also want to consider certain approaches within the index space that anchor more firmly on fundamentals or are a bit more valuation-sensitive. So, one example of a fund that we've long thought highly of is the Schwab U.S. Dividend Equity ETF. The ticker for that ETF is (SCHD). So, this is an equity-income-oriented ETF that looks at dividend yields and looks at dividend track records and strikes a nice balance between valuation discipline and quality. It looks for stocks that have a long history of paying and growing their dividends. So, approaches like this can help strike an appropriate balance. They simultaneously continue to leverage the wisdom of crowds, and the extent that this fund weights its 100 or so constituent stocks by market capitalization, and it boasts a low fee. It's 6 basis points. So, all of these factors underpin our Morningstar Analyst Rating of Silver for this ETF, which indicates our conviction that this is a fund that will in all likelihood outperform its category index over a long period of time.

Benz: Is a fund like this something that I would use to augment my S&P 500 or a total market exposure? Or would I use it instead of?

Johnson: It's really quite dynamic, Christine. So, many investors, it could be a perfectly suitable core holding. Other investors that might be interested in juicing their income stream a little bit, getting exposure to high-quality dividend-paying firms might be attracted to the fact that this fund as of now has a 4% SEC yield, which is competitive considering many of the alternatives. Now, this is still a stock portfolio, right? It's not cash money. It's not a savings account. There's no FDIC insurance. You're still buying stocks, and you're going to get all of the volatility that comes with that. But nonetheless, an attractive yield for a basket of stocks that should over a variety of different market conditions, and tough ones in particular, hold up better than the market at large.

Benz: And it also seems like assessing my baseline asset class exposures would also be something to take a look at at this juncture, maybe looking at my U.S. relative to non-U.S. or even my fixed income relative to equity exposure, that if these market segments are getting more concentrated, that arguably they're also maybe a little bit overvalued at this point?

Johnson: It's absolutely the case. So, your average investor at this point in time might be slightly overweight U.S. equity exposure relative to their target allocations. Within their U.S. equity exposure, they might be slightly overweight growth relative to value, and it may be time to revisit and rebalance those allocations.

Benz: Ben, really helpful discussion. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.