The S&P 500 Is More Concentrated Than You Think. These ETFs Spread Your Risk
When you buy through links on our articles, Future and its syndication partners may earn a commission.
Another investment strategy is making the rounds online. It’s called “S&P 500 and chill.” As the catchy phrase suggests, the first step in a simple formula is to buy a low-cost S&P 500 ETF.
From there, all you have to do is little dollar-cost averaging into your chosen exchange-traded fund on a set schedule. Be sure to make use of tax-sheltered accounts, reinvest distributions and let the rule of compounding work for the next 20 years or longer.
It’s not hard to see the appeal here. The S&P Indices Versus Active (SPIVA) research has repeatedly documented how difficult it is for professional stock pickers to beat the benchmark over long periods.
And S&P 500 exposure is exceptionally cheap. The State Street SPDR Portfolio S&P 500 ETF (SPYM) charges just 0.02%, equivalent to about $2 annually on a $10,000 investment.
Recent performance makes the strategy look even more compelling. Fueled partly by the long-running bull market in mega-cap technology and growth stocks, SPYM delivered a 15.4% annualized total return over the 10 years through September 30.
But today’s S&P 500 carries considerable concentration risk. As of October 7, tech stocks alone accounted for 40.2% of SPYM, which actually understates its exposure to technology-related businesses.
Alphabet (GOOGL), Meta Platforms (META) and Netflix (NFLX) are classified as communication services stocks, while Amazon (AMZN) and Tesla (TSLA) are consumer discretionary stocks.
Individual holdings tell a similar story. SPYM’s 10 largest positions accounted for 38.8% of the fund, with all of the Magnificent 7 stocks – including Apple (AAPL), Microsoft (MSFT) and Nvidia (NVDA) – represented among them.
One popular response has been equal weighting. The Invesco S&P 500 Equal Weight ETF (RSP) gives each S&P 500 constituent approximately the same starting weight at quarterly rebalances rather than allowing the largest companies to dominate.
Equal weighting has its own shortcomings. Ultimately, assigning both companies identical weights is an arbitrary choice. Weighting by market cap has an economic rationale. A company worth $1 trillion represents a larger portion of the investable stock market than one worth $10 billion.
Fortunately, you don’t have to choose between those two extremes. Several U.S. equity ETFs preserve the S&P 500’s basic characteristics, including exposure to U.S. large-cap stocks and substantial overlap in underlying companies.
They also use alternative weighting methodologies to reduce dependence on today’s biggest stocks. Better still, two standouts do it while keeping expenses reasonably low.
Tema S&P 500 Historical Weight ETF Strategy
An important feature of market-cap weighting is that nobody needs to decide how large each company’s allocation should be.
As a company’s share price and market value increase, its weight naturally rises. Companies that decline become smaller portions of the index. This creates a degree of self-cleansing and a built-in momentum effect, allowing winners to run.
Look at the S&P 500’s largest holdings at different points in history, however, and you’ll see how dramatically those proportions can change.
For investors who think today’s mega-cap concentration has moved too far from historical norms, the Tema S&P 500 Historical Weight ETF Strategy (DSPY) offers an interesting middle ground.
DSPY still owns the S&P 500 companies, and it keeps them in the same general rank order. So you’ll recognize the Magnificent 7 near the top.
The difference is how much weight they receive. Instead of using today’s market capitalizations alone, DSPY uses historical average S&P 500 constituent weights to moderate unusually large concentrations.
In effect, it’s still anchored to market-cap weighting, but with a look-back mechanism designed to pull extreme weights closer to historical norms.
According to the ETF Research Center’s Fund Overlap tool, compared with the S&P 500, DSPY has 7.8% less exposure to tech and 2.9% less to communication services.
Those reductions are redistributed primarily toward financial stocks, which receive a 2.7% overweight, with industrial stocks at 2.4% and healthcare stocks at 2.2%:
The differences are also visible at the company level. Mega-cap S&P stocks such as Nvidia, Apple and Microsoft remain among the fund’s largest holdings, but their individual weights are roughly half their conventional S&P 500 allocations.
Investors therefore retain exposure to the companies that have driven much of the index’s recent performance without allowing them to exert quite as much influence:
DSPY is more expensive than a plain-vanilla S&P 500 ETF, but not prohibitively so. Its 0.18% expense ratio works out to approximately $18 annually on a $10,000 investment.
And reducing mega-cap concentration hasn’t necessarily meant sacrificing recent returns. For the one-year period through August 31, DSPY returned 21.8% at net asset value, compared with 20.3% for SPYM.
That’s a short period and shouldn’t be extrapolated indefinitely. But it demonstrates that moderating the S&P 500’s largest weights doesn’t automatically mean giving up participation in a rising U.S. equity market.
Learn more about DSPY at the Tema ETFs provider site.
Invesco S&P 500 Revenue ETF
Market cap isn’t the only way to determine a company’s importance. Fundamental indexes can weight stocks according to earnings, dividends, free cash flow and other financial metrics.
The drawback is that many such strategies substantially depart from the S&P 500’s existing composition or exclude companies altogether when they fail to meet the methodology’s criteria.
The Invesco S&P 500 Revenue ETF (RWL) takes a simpler approach while retaining the S&P 500 constituent universe.
RWL reweights those companies according to their revenue, subject to a 5% individual-stock cap, with the portfolio rebalanced quarterly.
Revenue is the top line of the income statement, representing the money a company generates from selling goods and services before subtracting operating expenses, interest and taxes.
That makes revenue weighting considerably different from weighting by earnings, which measures what’s left after expenses, or free cash flow, which incorporates the cash generated by the business after operating and capital expenditures.
RWL emphasizes the scale of a company’s sales, rather than its profitability or cash generation.
That produces more pronounced changes than DSPY’s historical-weight approach. Fund Overlap shows RWL has a 23.2% underweight to tech relative to the S&P 500, accompanied by an 11.2% overweight to healthcare.
There’s still substantial overlap in the companies owned, but the importance assigned to them changes considerably:
If you’re accustomed to market-cap-weighted indexes, you might assume today’s mega-cap tech names are also America’s largest businesses by virtually every measure.
Revenue tells a different story. A consumer staples stock such as Walmart (WMT), which generates enormous sales from its retail operations, becomes much more prominent when we rank by the top line rather than market valuation:
RWL does have one significant disadvantage compared with DSPY: cost. Its 0.39% expense ratio translates into $39 annually for every $10,000 invested, making it substantially more expensive than either DSPY or a conventional S&P 500 ETF.
Recent performance has nevertheless been strong. For the one-year period through August 31, RWL returned 25.3% at net asset value, compared with 20.3% for SPYM over the same period.
As with DSPY, one year is far too short to establish the superiority of its methodology. But it shows how the same universe of S&P 500 companies can perform when revenue rather than market cap determines their weights.
Learn more about RWL at the Invesco provider site.