Concentration Risk in the S&P500

[Northern Flicker]

I've posted a few times about concerns of the S&P500 becoming too concentrated. It turns out that S&P has been relaxing cap weighting of Apple, Microsoft, and Nvidia so that S&P500 funds can comply with SEC regulations to qualifiy as a diversified fund.

https://www.wsj.com/finance/stocks/how- ... _permalink

[Lawrence of Suburbia]

Does this mean Vanguard will be selling off shares in those companies? ...

[Northern Flicker]

These would be index weight changes that S&P500 funds would have to implement to track the index.

[muffins14]

I've posted a few times about concerns of the S&P500 becoming too concentrated. It turns out that S&P has been relaxing cap weighting of Apple, Microsoft, and Nvidia so that S&P500 funds can comply with SEC regulations to qualifiy as a diversified fund.

https://www.wsj.com/finance/stocks/how- ... _permalink

Although these companies are indeed in the S&P 500, it seems that this article is about the technology index.

For example it seems nothing would happen until the companies making up more than 5% of the index sum to be more than 50% of the index. That seems to not be the case for the S&P500. It is about 20% of the index, pretty far from 50%

[Northern Flicker]

Maybe I was over-interpreting, but my assumption is that the standalone tech index remains as the tech sector of the S&P500 so that it also has affected S&P500 funds.

[muffins14]

Maybe I was over-interpreting, but my assumption is that the standalone tech index remains as the tech sector of the S&P500 so that it also has affected S&P500 funds.

I think the S&P 500 is built independently by looking at about the top 500 companies across any sector, rather than by being built from a combination of smaller sector-specific indices that are somehow averaged to become the final S&P 500 index

Or do you mean that the buying/selling done by the technology index fund would move the market, thus impacting the market value of AAPL, MSFT, NVDA, thus affecting an S&P500 fund like VOO?

[alluringreality]

Does this mean Vanguard will be selling off shares in those companies? ...

I only briefly skimmed the recent stories about the prior S&P methodology. I'm pretty sure it doesn't apply to my holdings, which includes the S&P 500. I think Vanguard sector funds use MSCI instead of S&P indexes, and they were unaffected by the S&P sector indexing issue under discussion. The product page has a FAQ on the change.
https://www.ssga.com/library-content/pr ... pdates.pdf

Although these companies are indeed in the S&P 500, it seems that this article is about the technology index.

For example it seems nothing would happen until the companies making up more than 5% of the index sum to be more than 50% of the index. That seems to not be the case for the S&P500. It is about 20% of the index, pretty far from 50%

While I agree about the first part, I think the last part depends if the fund is classified as diversified or non-diversified. The fund under discussion appears to be noted as non-diversified in the summary prospectus. I haven't looked too far into the details about these things, but I think diversified funds have to keep under 25% for stocks above 5% at reconstitution.

[toddthebod]

That article is about the SDPR information technology fund. It has nothing to do with, and there have been no changes to, the S&P 500.

[Beensabu]

Holy smokes. Let's not bury the lead here, shall we?

To comply with the 50% rule, S&P had traditionally capped the weight of the smallest constituent with a greater than 5% weight until an index was back below the concentration threshold.

So in early June, NVDA had a 6% weight (because AAPL and MSFT each had 22%). And you can't go over 50%.

And then at the June rebalance, NVDA ended up with greater market capitalization than AAPL (making AAPL the smallest constituent with a greater than 5% weight), so they had to sell AAPL and buy NVDA - and this gave AAPL a 4.5% weight and NVDA and MSFT almost 21% each. Funds tracking that index had to sell a crazy amount of AAPL to buy a crazy amount of NVDA super high.

That's the story, people. That's insane.

But at least now that won't happen again:

To address the issue, S&P changed its methodology to comply with the rules ahead of its Sept. 20 rebalance. The index provider lowered the weights of all three companies proportional to their market cap, until they collectively comprised less than 50% of the SPDR fund.

[muffins14]

Holy smokes. Let's not bury the lead here, shall we?

To comply with the 50% rule, S&P had traditionally capped the weight of the smallest constituent with a greater than 5% weight until an index was back below the concentration threshold.

So in early June, NVDA had a 6% weight (because AAPL and MSFT each had 22%). And you can't go over 50%.

And then at the June rebalance, NVDA ended up with greater market capitalization than AAPL (making AAPL the smallest constituent with a greater than 5% weight), so they had to sell AAPL and buy NVDA - and this gave AAPL a 4.5% weight and NVDA and MSFT almost 21% each. Funds tracking that index had to sell a crazy amount of AAPL to buy a crazy amount of NVDA super high.

That's the story, people. That's insane.

But at least now that won't happen again:

To address the issue, S&P changed its methodology to comply with the rules ahead of its Sept. 20 rebalance. The index provider lowered the weights of all three companies proportional to their market cap, until they collectively comprised less than 50% of the SPDR fund.

This is perhaps a good reason to avoid sector funds with a small number of holdings

[Beensabu]

This is perhaps a good reason to avoid sector funds with a small number of holdings

Or keep them in tax-advantaged and keep an eye on them. But yes, that way ^ is easier for sure.

[nisiprius]

Maybe I was over-interpreting, but my assumption is that the standalone tech index remains as the tech sector of the S&P500 so that it also has affected S&P500 funds.

No, an S&P 500 index funds is not fund-of-funds made up of eleven holdings of S&P Select Sector index funds.

The press has gone nuts ignorantly or intentionally confusing one S&P index, the S&P Select Technology Index, with "the S&P," i.e. the S&P 500 Index. (Dow Jones S&P provides 130,000 different indexes, by the way).

It reminds me of the time back August of 2016, when GICS elevated REITS and real-estate-related businesses to the status of a headline sector; there had been ten before, with REITs being part of the financial sector.

There was an astonishing amount of garbage in the financial press claiming that this would be an seismic event for the market and for S&P 500 index funds, which were now (they said) going to need to run out and buy vast quantities of REITs all at the same time. This would have been true if the S&P 500 were an equal weighted portfolio of the headline sectors. But it isn't. It's just cap-weighted at the individual stock level. If Simon Property Group is 0.11% of the stock market, it is still 0.11% of the stock market regardless of whether it is classified as a financial or as real estate, and it doesn't get any bigger or small just because MSCI and S&P decided to change the classification.

Same thing with this one. It affects those who hold XLK, which seems to be the only ETF which tracks the S&P Select Technology Sector. I'm not sure it affects them much. In any case, XLK has about $70 billion in assets, while the market has about $50,000 billion in assets, so whatever buying and selling XLK needs to do should be easily absorbed by the market.

My crystal ball says it might affect who hold technology sector index ETFs tracking other providers' indexes, because they might decide to follow suit. Again, I don't know if would affect them much.

Offhand I can't think of any reason why this would cause a ripple in S&P 500 index funds or in total market index funds.

[Northern Flicker]

Maybe I was over-interpreting, but my assumption is that the standalone tech index remains as the tech sector of the S&P500 so that it also has affected S&P500 funds.

No, an S&P 500 index funds is not fund-of-funds made up of eleven holdings of S&P Select Sector index funds.

The press has gone nuts ignorantly or intentionally confusing one S&P index, the S&P Select Technology Index, with "the S&P," i.e. the S&P 500 Index. (Dow Jones S&P provides 130,000 different indexes, by the way).

Not a fund of funds, and not even the identical makeup because the sector funds are not limited to large caps, but I've always assumed that a sector would not have different relative weightings of included securities for different indices of which the sector is a part.

The ripple effect is that not only is the tech sector a large part of the market or especially of the large cap index, but the sector itself has so much individual stock concentration that the sector index has needed the described adjustment. This increases the concentration risk associated with a given sector allocation, and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.

The main point that this is indicative of heightened tech sector concentration risk in the S&P500 as an example.

[nisiprius]

...Not a fund of funds, and not even the identical makeup because the sector funds are not limited to large caps, but I've always assumed that a sector would not have different relative weightings of included securities for different indices of which the sector is a part...

So I looked it up. S&P US Indices Methodology, September 2024

p. 4:

The S&P U.S. Indices are a family of equity indices designed to measure the market performance of U.S.
domiciled stocks trading on U.S. exchanges. The family is composed of a wide range of indices based on
size, sector, and style. The indices are weighted by float-adjusted market capitalization (FMC). In
addition, equal weighted and capped market capitalization weighted indices are also available as detailed
below.

p. 5:

S&P Capped Market Capitalization Weighted U.S. Indices. The indices include the Select Sector
Indices, S&P Select Sector Capped 20% Indices, S&P Select Sector Daily Capped 25/20 Indices, S&P
Select Sector 15/60 Capped Indices, S&P 500 Capped 35/20 Indices, S&P MidCap 400 Capped Sector
Indices, and S&P SmallCap 600 Capped Sector Indices. Index constituents are drawn from their
respective underlying index (i.e., the S&P 500, S&P MidCap 400 or S&P SmallCap 600) and selected for
index inclusion based on their GICS classification. Instead of weighting by float-adjusted market
capitalization, the indices employ a capped market capitalization weighting scheme and specific capping
methodology.

p. 14:

The methodology for capped indices follows an identical approach to market cap weighted indices except
that the indices apply an additional weight factor, or “AWF”, to adjust the float-adjusted market
capitalization to a value such that the index weight constraints are satisfied.

So it's saying explicitly that a) stocks are given different relative weights in the S&P 500 index than in the "capped indices," and also that the S&P Select Sector indexes are examples of "capped indices." Which speaks to your question.

I used the archive.org Wayback machine to download a version of the document from May, 2020, and the p. 5 language is identical. So the Select Sector Indexes have always been capped, and in addition they offer an amazing variety of sector indexes with different capping protocols. Apparently this hasn't changed, all that's changed recently is that they have revamped the capping methodology for the already-capped Select Sector Indexes.

[Beensabu]

So the Select Sector Indexes have always been capped, and in addition they offer an amazing variety of sector indexes with different capping protocols. Apparently this hasn't changed, all that's changed recently is that they have revamped the capping methodology for the already-capped Select Sector Indexes.

The interesting part is why they changed the capping methodology.

It means that when they instituted the original methodology, they didn't foresee this particular scenario ever occurring... And that is interesting.

[arcticpineapplecorp.]

Maybe I was over-interpreting, but my assumption is that the standalone tech index remains as the tech sector of the S&P500 so that it also has affected S&P500 funds.

i think you're overinterpreting. I see numerous mentions thoughout the article referencing the SPDR technology index, not the S&P500 index which includes all sectors.

Concentration issues are most prominent in sector indexes that offer investors focused exposure

[muffins14]

The ripple effect is that not only is the tech sector a large part of the market or especially of the large cap index, but the sector itself has so much individual stock concentration that the sector index has needed the described adjustment. This increases the concentration risk associated with a given sector allocation, and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.

I don’t think we know what you mean by “ and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.”

The S&P500 is a different index than the S&P tech index, so tech being concentrated doesn’t imply that the S&P500 is concentrated. It has a lot more stocks and follows a different index. Why would you need to “adjust” the S&P500 due to the concentration of a different index?

[retiringwhen]

BTW, this same type of adjustment is being done with VUG/VIGAX (Vanguard Growth Index) for the last 2 quarters and VGK (Vanguard MegaCap Growth Index) for about 2 years now.

The methodology is clearly laid out in the CRSP Index Methodology document.

The Total Market, LargeCap, Value and MegaCap index funds are not impacted.

This is essentially the same problem as the S&P Tech index is having since the Magnificent Seven are all crowded in the same quadrant.

[Beensabu]

The ripple effect is that not only is the tech sector a large part of the market or especially of the large cap index, but the sector itself has so much individual stock concentration that the sector index has needed the described adjustment. This increases the concentration risk associated with a given sector allocation, and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.

I don’t think we know what you mean by “ and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.”

The S&P500 is a different index than the S&P tech index, so tech being concentrated doesn’t imply that the S&P500 is concentrated. It has a lot more stocks and follows a different index. Why would you need to “adjust” the S&P500 due to the concentration of a different index?

Because the companies creating the concentration in the sector index are also the most heavily weighted companies in the S&P 500 index.

I wouldn't rule out the possibility of S&P instituting caps on the S&P 500 index at some unknown point in the future.

They just had to change the cap methodology on an already capped index because a scenario nobody in the past anticipated actually materialized and forced them to do so.

That should tell you that the situation we find ourselves in with regards to concentration in the tech sector (and arguably concentration in S&P 500 or US market) is so unusual that it was completely unanticipated. They really thought their previous capping methodology was good enough. And it was, for a very long time. But not right now.

Similarly, Morningstar recently changed their style box methodology to make market cap weighting "style neutral". Because of the situation we find ourselves in. It wasn't necessary before. Their previous methodology was good enough, for a long time. But not right now.

I don't know about you, but if I see indications of something being good enough for a long time but not right now popping up here and popping up there, that's food for thought. At the very least.

[Beensabu]

Btw, VGT is going to violate the 25/5/50 rule in the article if Broadcom capitalization goes up to increase its weighting over 5% and the capitalization of any of the top 3 companies in that fund changes to increase their weighting barely at all.

[Northern Flicker]

The ripple effect is that not only is the tech sector a large part of the market or especially of the large cap index, but the sector itself has so much individual stock concentration that the sector index has needed the described adjustment. This increases the concentration risk associated with a given sector allocation, and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.

I don’t think we know what you mean by “ and if not adjusted in the S&P500 or total market, then the resulting concentration risk is left intact.”

Per nisiprius's posting, weightings are adjusted in the S&P500 in any case.

But the prior text of the paragraph still applies. Individual stock concentration in the tech sector amplifies the concentration risk of the high ttch sector weighting.

[Lyrrad]

I've posted a few times about concerns of the S&P500 becoming too concentrated. It turns out that S&P has been relaxing cap weighting of Apple, Microsoft, and Nvidia so that S&P500 funds can comply with SEC regulations to qualifiy as a diversified fund.

https://www.wsj.com/finance/stocks/how- ... _permalink

I find the topic title and the first post to be misleading.

As as discussed in this thread and the article, it does not currently apply to the S&P 500 index, only the "S&P 500 Information Technology" index.

[Northern Flicker]

That the concentration risk of individual stocks in the tech sector is at the described level amplifies the concentration risk of the large allocation to tech in the S&P500, so I will stand by the thread title.

[UpperNwGuy]

That the concentration risk of individual stocks in the tech sector is at the described level amplifies the concentration risk of the large allocation to tech in the S&P500, so I will stand by the thread title.

I don't follow your logic.

[Beensabu]

That the concentration risk of individual stocks in the tech sector is at the described level amplifies the concentration risk of the large allocation to tech in the S&P500, so I will stand by the thread title.

I don't follow your logic.

Let's say there's a risk that shows up in emerging markets.

You are not invested in VWO (emerging markets).

But you are invested in VXUS (total international), which includes emerging markets.

You are subject to less of that risk in VXUS than you would be in VWO, but you are still subject to that risk.

[toddthebod]

The problem lies in the arbitrary definition of tech. There is only super concentration in the so-called tech sector because they leave out so many large tech companies.

How can you possibly take this index change as serious news when adding missing tech companies makes the problem go away?!

[Northern Flicker]

That the concentration risk of individual stocks in the tech sector is at the described level amplifies the concentration risk of the large allocation to tech in the S&P500, so I will stand by the thread title.

I don't follow your logic.

If the tech sector hypothetically consisted of a single company stock, a 40% allocation to the tech sector would be much more concentration risk than a 40% allocation to a tech sector with 50 cap-weighted stocks. Individual stock concentration within the tech sector amplifies the concentration risk of an outsize allocation to the sector.

[Northern Flicker]

The problem lies in the arbitrary definition of tech. There is only super concentration in the so-called tech sector because they leave out so many large tech companies.

How can you possibly take this index change as serious news when adding missing tech companies makes the problem go away?!

In terms of evaluating the S&P500, this line of reasoning would be that we only get to 40% tech in the SP500 if communications sector companies like Google/Alphabet or Facebook/Meta are included, while the extreme individual concentration of the tech sector is with them excluded.

A counterpoint to that would be that even with such companies excluded, tech is still 31% of the S&P500.

[muffins14]

That the concentration risk of individual stocks in the tech sector is at the described level amplifies the concentration risk of the large allocation to tech in the S&P500, so I will stand by the thread title.

I don't follow your logic.

If the tech sector hypothetically consisted of a single company stock, a 40% allocation to the tech sector would be much more concentration risk than a 40% allocation to a tech sector with 50 cap-weighted stocks. Individual stock concentration within the tech sector amplifies the concentration risk of an outsize allocation to the sector.

In what way is it “amplified” rather than “the same”?

Let’s say the tech sector was one mega stock. So the S&P500 now has 31% in that single stock and 69% in the other 499 stocks.

Is that amplified compared to the fact that the tech sector index is one stock? I would agree that’s a quite concentrated portfolio due to the mega stock, but it’s because that stock is so large, not because the tech index is concentrated.

In causal terms, the stock being big causes a) the s&P500 to be more concentrated and b) the tech index to be more concentrated. The tech index being more concentrated has no effect on the S&P500 being more concentrated.

[alluringreality]

The tech index being more concentrated has no effect on the S&P500 being more concentrated.

My comment regarding the 75-5-10 rule was not accurate.
viewtopic.php?p=8059024#p8059024

[muffins14]

The tech index being more concentrated has no effect on the S&P500 being more concentrated.

I think in the hypothetical the S&P 500 would have to advertise as non-diversified, rather than using the diversified 75-5-10 criteria.
viewtopic.php?t=176714

But that is not because the tech index is concentrated, it is because there’s a very large hypothetical stock that just so happens to be tech

[nisiprius]

The tech index being more concentrated has no effect on the S&P500 being more concentrated.

I think in the hypothetical the S&P 500 would have to advertise as non-diversified, rather than using the diversified 75-5-10 rule.
viewtopic.php?t=176714

I realized, way too late in these multiple discussions, that I have been confused by the 75-5-10 rule, which controls whether a fund can market itself as "diversified," versus a rule I didn't know about: a 25-5-50 rule, that apparently relates to whether a fund is diversified enough to be a regulated investment company (RIC).

My dumb web searches for things like 25-5-50 ric diversification rule yielded surprisingly little information on this. Mostly throwaway asides in articles about the XLK revamp.

The consequences of violating the rule would be much more serious than simply having to call the fund "nondiversified." Apparently, it is qualifying as a regulated investment company that allows a fund to pass through dividends without paying corporate income tax on them.

[retiringwhen]

I realized, way too late in these multiple discussions, that I have been confused by the 75-5-10 rule, which controls whether a fund can market itself as "diversified," versus a rule I didn't know about: a 25-5-50 rule, that apparently relates to whether a fund is diversified enough to be a regulated investment company (RIC).

The CRSP Methodology Guide has a very nice concise overview of the 25-5-50 rule in Chapter 9 of their guide. That part is general purpose, but the rest describes how CRSP implement mitigations, that is not applicable in other places. See: Page 60

The Internal Revenue Service has established rules for a fund to qualify as a Regulated Investment Company (RIC). In other
words, the IRS rules impose limits on the holdings of RICs. These rules state that at the end of each quarter of a RIC’s tax year,
• No more than 25 percent of the value of the RIC’s assets may be invested in a single issuer
• The sum of the weights of all issuers representing more than 5 percent of the fund’s total assets should not exceed 50 percent

[nisiprius]

Yeah, and capped funds have been quite common for a long time. It's not as if it is something that just came along this year. A lot of international stock funds are capped, for example. I just hadn't paid attention because they weren't funds that interested me. Pure tech funds like XLK or VGT still don't interest me.

The Vanguard 500 ETF currently has three holdings over 5%: Apple, Microsoft, and NVIDIA, totaling 6.97 + 6.54 + 6.20 = 19.27% which is a ways away from 50%, and after those three the runners-up have weights like 3.45%, 2.41%, 2.03% so I think it is a good way away from breaking the 25-5-50 rule, and Total Stock is a slightly away.

[Lyrrad]

I realized, way too late in these multiple discussions, that I have been confused by the 75-5-10 rule, which controls whether a fund can market itself as "diversified," versus a rule I didn't know about: a 25-5-50 rule, that apparently relates to whether a fund is diversified enough to be a regulated investment company (RIC).

The CRSP Methodology Guide has a very nice concise overview of the 25-5-50 rule in Chapter 9 of their guide. That part is general purpose, but the rest describes how CRSP implement mitigations, that is not applicable in other places. See: Page 60

The Internal Revenue Service has established rules for a fund to qualify as a Regulated Investment Company (RIC). In other
words, the IRS rules impose limits on the holdings of RICs. These rules state that at the end of each quarter of a RIC’s tax year,
• No more than 25 percent of the value of the RIC’s assets may be invested in a single issuer
• The sum of the weights of all issuers representing more than 5 percent of the fund’s total assets should not exceed 50 percent

Based on the holdings of VOO (Vanguard S&P 500 ETF) as of August 31, 2024, the S&P 500 is far away from these limits.

The highest concentration in one company is 6.97%, and there are 3 companies over 5%, adding up to 19.71%.

I think VNQ (Vanguard Real Estate ETF) uses VRTPX (Vanguard Real Estate II Index Fund Institutional Plus Shares) to try to get around ownership limitations, though perhaps it was a different limitation imposed by the REITS themselves preventing a single fund from owning too large a percentage of any one company.

Vanguard supplemented their prospectuses in July 2024 with information about Ownership Limitations.

In any case, if the S&P 500 is modified from a free-float market-cap weighting, I'll consider buying individual shares of the underweight companies. I'd also consider switching to a Total US Stock market index fund which would be less likely to be affected by limitations.

[alluringreality]

The CRSP Methodology Guide has a very nice concise overview of the 25-5-50 rule in Chapter 9 of their guide.

Thanks for the note. The 31% hypothetical would appear to violate the 25% single company limit. It looks like Vanguard's S&P 500 fund is not currently subject to the 75-5-10 rule.
https://www.reddit.com/r/Bogleheads/com ... _vanguard/
viewtopic.php?t=435051

[retiringwhen]

I'd also consider switching to a Total US Stock market index fund which would be less likely to be affected by limitations.

This is a very good justification for sticking Total Market Indexes. I did a TLH back in 2018 from VTSAX -> VUG/VIGAX, VTV/VVIAX, VB/VSMAX.

From a tax perspective it is likely the single most profitable tactical investment decision I have ever made (on the order of 6 figures, thanks @livesoft!), but it has complicated following my Total Market investment strategy documented in my IPS.

One of those complications is that In the past two years, I have been having to get knowledgeable of the 25-5-50 rule in order to understand just what the split is between VTV and VUG since those indexes move widely from an AA perspective and a simple calculation using published MarketCaps no longer works.

[Northern Flicker]

If the tech sector hypothetically consisted of a single company stock, a 40% allocation to the tech sector would be much more concentration risk than a 40% allocation to a tech sector with 50 cap-weighted stocks. Individual stock concentration within the tech sector amplifies the concentration risk of an outsize allocation to the sector.

In what way is it “amplified” rather than “the same”?

Sector risk is at least somewhat more likely to materialize and at least somewhat likely to be more severe if the sector itself is less diversified.

[nisiprius]

I think throwing in sectors just confuses the issue without adding anything. The stock market isn't a collection of sector funds, it's just a collection of stocks. The question of whether the S&P 500 is "too" concentrated can be decided just by looking at the market capitalization of all the individuals stocks in the market. I don't think drawing circles around groups of them and doing a two-stage analysis of stocks within sectors and sectors within the total market doesn't clarify anything or add any insights.

Consider 2016. There were ten sectors. MSCI and S&P decided to take all of the REITs out of the Financials sector, and put it into a new, freshly created, eleventh Real Estate sector. That almost certainly made the Financials sector less diverse. But however you choose to measure "diversity" it did not change the diversity of the market as a whole, because it did not change the composition of the market as a whole.

And it certainly doesn't help matters to take three companies in the information technology sector (Apple, Microsoft, NVIDIA), and then add two companies in consumer discretionary (Amazon and Tesla), and two more in communications services (Alphabet and Meta), create a name ("the Magnificent Seven") for that somewhat diverse package, and view with alarm how big it is. There isn't any "Magnificent Sector."

No matter what happens inside XLK, or any other tech index ETFs if they follow suit, it just means that these particular investment products have decided to adjust their holdings mix. It does not change the number of Apple shares in the market, the number of NVIDIA shares in the market, or the market capitalization of either company. It does not create or destroy any shares of stock. It does not move one share of stock into or out of the S&P 500, into or out of any S&P 500 index fund, into or out of any total market index fund. The composition of the market remains unchanged.

Of course, XLK, the Technology Select Sector SPDR Fund--the only fund immediately affected by the change in the index--is not a member of the S&P 500. But to show the scale of things, I've added it, to put it into proportion with the sizes of the S&P 500 as a whole, Apple, and NVIDIA.

[Northern Flicker]

I think throwing in sectors just confuses the issue without adding anything. The stock market isn't a collection of sector funds, it's just a collection of stocks.

The market is made up of sectors which in turn are made up of stocks. The fact that a market index fund or an S&P500 fund does not hold a collection of sector funds is a red herring.

Sector risk is a diversifiable risk, and thus is an uncompensated risk. From: https://quantrl.com/diversifiable-vs-no ... able-risk/

Diversifiable risk, also known as unsystematic risk, arises from specific factors related to individual investments or sectors.

[muffins14]

I think throwing in sectors just confuses the issue without adding anything. The stock market isn't a collection of sector funds, it's just a collection of stocks.

The market is made up of sectors which in turn are made up of stocks. The fact that a market index fund or an S&P500 fund does not hold a collection of sector funds is a red herring.

Sector risk is a diversifiable risk, and thus is an uncompensated risk. From: https://quantrl.com/diversifiable-vs-no ... able-risk/

Diversifiable risk, also known as unsystematic risk, arises from specific factors related to individual investments or sectors.

I still don’t think the sector index being concentrated has any impact on the S&P500 being concentrated.

For example say there is a new sector called MyCoolSector. It has 1 stock at 100% of the sector. MyCoolSector makes up 1% of the total market.

The S&P500 is not at risk of being concentrated just because MyCoolSector is concentrated.

Similarly, the S&P500 is not at risk of being concentrated because the tech sector is concentrated. it is at risk of being concentrated because there are a handful of very large stocks, full stop.

If your whole portfolio was 100% MyCoolSector index, that would be sector risk and would be diversifiable.

[Northern Flicker]

Sector risk and security-specific (individual stock) risk are two different risks. While I agree that having a sector with just a few stocks will tend to blur the two, sector risk refers to the business risk of the sector's business while security-specific risk refers to risks unique to a particular company. Both sector risk and security-specific risk are sources of diversifiable concentration risk.

The reason I believe that a sector with high individual stock concentration has a higher sector risk than a sector without such high individual stock concentration is that individual companies do business risk management and have contingency plans. These mitigating factors for sector business risk are more diversified in a more diversified sector.

A portfolio with a high percentage in a single sector has diversifiable sector risk. Ultimately, either we agree that a sector that is internally undiversified is riskier than one that isn't, or we don't. If we don't, I doubt that we will reach consensus on that.

[Lyrrad]

Sector risk and security-specific (individual stock) risk are two different risks. While I agree that having a sector with just a few stocks will tend to blur the two, sector risk refers to the business risk of the sector's business while security-specific risk refers to risks unique to a particular company. Both sector risk and security-specific risk are sources of diversifiable concentration risk.

The reason I believe that a sector with high individual stock concentration has a higher sector risk than a sector without such high individual stock concentration is that individual companies do business risk management and have contingency plans. These mitigating factors for sector business risk are more diversified in a more diversified sector.

A portfolio with a high percentage in a single sector has diversifiable sector risk. Ultimately, either we agree that a sector that is internally undiversified is riskier than one that isn't, or we don't. If we don't, I doubt that we will reach consensus on that.

I don't think I'm fully understanding this argument. If I understand correctly, you are trying to say that a high concentration in a few companies in a S&P 500 sector like Information Technology increases the risk of the S&P 500 index as a whole.

My understanding is that the S&P 500 index in composed of 500 individual companies and is free-float market capitalization weighted. (As of the end of June 2024, The 500 companies in the index are about 88% of the holdings of the Vanguard Total US Stock Market fund by value.)

Then, the S&P classifies each of the 500 companies into one of eleven "sectors", and calculates and sells an index product for each of them. Some of these sectors contain companies that are a large percentage of the total market cap of the sector, so S&P decides to cap some weightings in these indexes so that an index fund based on these sectors can be a RIC.

I can understand the reasoning why some would not want to have a large portion of their stock index fund in a small number of companies. It also makes sense to me that a particular sector index fund consisting mostly of a few large companies might be considered riskier by some than another sector index fund with more equal weightings.

However, I don't follow why a particular (potentially arbitrary) sector definition with a few large companies would necessarily cause a "concentration risk" problem with the entire S&P 500 index.

[Beensabu]

However, I don't follow why a particular (potentially arbitrary) sector definition with a few large companies would necessarily cause a "concentration risk" problem with the entire S&P 500 index.

I think they are saying that a less diversified sector means a greater possibility of "contagion" across that sector (as well as related industries). And since the few large companies currently creating massive concentration in a particular sector are also the largest companies in the S&P 500, the potential ripple effect they can cause (for better or worse) increases along with their capitalization and market dominance.

It's a harbinger, if you will.

[Northern Flicker]

I don't think I'm fully understanding this argument. If I understand correctly, you are trying to say that a high concentration in a few companies in a S&P 500 sector like Information Technology increases the risk of the S&P 500 index as a whole.

I think there are two separate concerns. The primary concern is just sector concentration. Sector concentration risk is diversifiable and hence uncompensated. Tech companies in the tech and communication sectors total about 40% of the market cap of the index. Is that at a level where it adds a diversifiable, uncompensated risk? You will have to decide. I don't think there is an established percentage threshold for that. I rate it as a concern. That does not mean that the S&P500 won't or can't overperform the market for the next 50 years, but I think it is a legitimate concern to understand when a portfolio has diversifiable sector concentration risk.

A second concern is the concentration in the tech sector may amplify the sector risk of a large allocation to the sector.

Holding the market portfolio addresses a little of the concern-- tech and communications is about 37% of the index, and the tech sector is a little more diversified.

I'm just raising the concerns I have with this and the reasons for the concerns. I am not going to make a portfolio recommendation around the issue, but I do think investors would do well to decide for themselves what risks they are willing to take.

Our current equity holdings are roughly 62% vtclx 10% vtmsx 28% vxus, so about 28% ex-US and a fairly mild size tilt for US equities. A goal for us is not to have over 25% in any de facto sector, which is approximately, but maybe not quite achieved there.

[BitTooAggressive]

I don't think I'm fully understanding this argument. If I understand correctly, you are trying to say that a high concentration in a few companies in a S&P 500 sector like Information Technology increases the risk of the S&P 500 index as a whole.

I think there are two separate concerns. The primary concern is just sector concentration. Sector concentration risk is diversifiable and hence uncompensated. Tech companies in the tech and communication sectors total about 40% of the market cap of the index. Is that at a level where it adds a diversifiable, uncompensated risk? You will have to decide. I don't think there is an established percentage threshold for that. I rate it as a concern. That does not mean that the S&P500 won't or can't overperform the market for the next 50 years, but I think it is a legitimate concern to understand when a portfolio has diversifiable sector concentration risk.

A second concern is the concentration in the tech sector may amplify the sector risk of a large allocation to the sector.

Holding the market portfolio addresses a little of the concern-- tech and communications is about 37% of the index, and the tech sector is a little more diversified.

I'm just raising the concerns I have with this and the reasons for the concerns. I am not going to make a portfolio recommendation around the issue, but I do think investors would do well to decide for themselves what risks they are willing to take.

Our current equity holdings are roughly 62% vtclx 10% vtmsx 28% vxus, so about 28% ex-US and a fairly mild size tilt for US equities. A goal for us is not to have over 25% in any de facto sector, which is approximately, but maybe not quite achieved there.

I agree with this but I would make portfolio recommendations if you only hold US total stock market or SP500.

My recommendation is to diversity. On my equities I hold 38% in US total market my largest holding. But I also small cap value US and international along with VXUS. I know any of those can get overvalued or go through bad times. But I certainly don’t concern myself with high US concentrations because it will not be my entire equity return.

[rkhusky]

The number of sectors and the sector boundaries are arbitrary and there is always a large variation in the allocation to different sectors in the market.

If you tried to create an equal allocation to the different sectors, you would have issues as the economy changed.

[Northern Flicker]

Right. I don't try to weight sectors equally.

[arcticpineapplecorp.]

whoever termed the 7 stocks the "Magnificant Seven" obviously didn't see the movie. Spoiler alert: only three of the seven survived.

remember it was once FAANG in 2020? The "N" didn't stand for Nvidia. It stood for Netflix which apparently is not as magnificant as it was in 2020 because now it's the 23rd biggest company in VOO.

but the market goes up over time because the companies that replace other companies in the top 10 create more value than those they replaced.

[Northern Flicker]

but the market goes up over time because the companies that replace other companies in the top 10 create more value than those they replaced.

If market risk hypothetically were elevated due to higher than average sector concentration, is there any reason to believe that the remaining market segments would deliver enough excess expected return to compensate for the elevated risk?