3 diversification strategies you can use now

The S&P 500 is one of the most well-known stock indexes in the world. It consists of 500 of the largest publicly traded US companies and is a staple of institutional and private portfolios. It has even received the endorsement of Warren Buffett, who once said, “In my view, the best thing for most people is to own an S&P 500 index fund.”

Buffett’s proposal to develop the S&P 500 was intended to provide the average investor with diversified exposure to the stock market. However, the composition of the S&P 500 has changed significantly over the years, and many investors may not be aware that the index is at a record high level of concentration. This concentration poses significant risks because the index’s performance is highly dependent on the success of a few companies.

The top 10 companies now account for over 35% of the index’s market capitalization, reflecting the dominance of tech giants and the rise of artificial intelligence. This high concentration reduces diversification benefits and makes portfolios extremely vulnerable to sector-specific downturns or company-specific issues.

Over the past two years, heavily weighting technology and large-cap growth stocks has paid off for investors. Fortunately, there are several low-cost ways to take some chips off the table and switch exposure to other low-cost, more diversified indexes.

Stay in the S&P 500, but switch to a balanced weighting

One way to diversify the typical market-cap-weighted S&P 500 exposure is to stay in the same companies but use an equal-weighted approach. This strategy, which can be implemented with an ETF like RSP, the Invesco S&P 500 Equal Weight ETF, provides equal exposure to all 500 companies in the index. This approach ensures that no single company disproportionately influences the index’s performance. The top 10 stocks make up just 2.8% of the portfolio.

The equal-weighted index also has a lower price-to-earnings ratio (19x) than the market-cap-weighted index (22.5x) because it is less dependent on the trillion-dollar, high-growth, high-P/E technology stocks that dominate the S&P 500. In other words, investors concerned about the rising valuations of giant technology companies can reduce the risk of a P/E correction in the event of a recession or other event.

Microsoft, Nvidia and Apple each have a market capitalization of more than $3 trillion and together make up more than 20% of the index. To put concentration risk in context, the 50th largest company in the S&P 500 is currently Philip Morris, with a weight of 0.36%. Philip Morris would have to rise or fall by about 20% to have the same impact on the index as a 1% move in Microsoft, which has a weight of 7%.

While they help with diversification, equal-weight ETFs carry some risk. They tend to be more heavily invested in smaller companies, which can be more volatile than large-cap stocks. They also tend to charge higher management fees due to higher trading costs and the need for quarterly rebalancing.

Increase your exposure to small caps

Small-cap stocks are companies with a market capitalization of less than $2 billion. These companies often have higher growth potential compared to large-cap stocks and have produced higher long-term returns. One of the most liquid ways to gain exposure to small-cap companies is through IWM’s iShares Russell 2000 ETF. IWM holds 2000 domestic stocks; the top 10 companies together account for 5.6% of the portfolio.

The performance of small-cap stocks has lagged that of large-cap stocks in recent years. IWM, for example, is still 17% below its 2021 peak while the S&P 500 is hitting new highs. If small-cap stocks come back into fashion, the gap to past performance could narrow.

One reason for the recent underperformance of smaller companies relative to the large-cap stocks in the S&P 500 is interest rate sensitivity. Small caps typically have higher leverage and lower debt service coverage ratios, so the rise in interest rates over the past two years has disproportionately negatively impacted stocks in the small cap universe. Now that inflation is falling, a corresponding decline in interest rates could be the catalyst that begins to close the performance gap between IWM and the S&P 500.

Small-cap stocks are generally more volatile and can experience greater price swings, especially during economic downturns. As mentioned above, they are also relatively sensitive to interest rate changes, so a resurgence in inflation and a subsequent rise in yields could hurt performance. Nevertheless, small-cap stocks are currently at their cheapest levels in years compared to large-cap stocks, making them an attractive diversification alternative.

Consider an allocation to international equities

When it comes to diversification, many investors are underweight international equities in their portfolios. International ETFs provide exposure to companies outside the U.S., offering geographic diversification and reducing dependence on the U.S. market. Investing in international equities can also provide currency diversification, which can be beneficial during times of U.S. dollar weakness.

An easy and inexpensive way to gain exposure to international stocks is the Vanguard All-World Ex-US ETF, VXUS. It holds over 8,600 stocks of all sizes in developed and emerging markets. The top 10 stocks make up 11.4% of the ETF. Essentially, VXUS owns the majority of public stocks traded outside the US.

Like U.S. small-cap stocks, international stocks have also lagged the S&P 500 in recent years. The strength of the U.S. dollar, lower exposure to growth stocks and slower earnings growth are some reasons for the underperformance. From a valuation perspective, international stocks are relatively cheap. VXUS’s P/E ratio is 14.9, a multi-decade low compared to the S&P 500.

International investing is subject to political, economic and regulatory risks that may not be present in the U.S. market. In addition, exchange rate fluctuations can affect the returns of international ETFs and add volatility. Despite some additional risks, the diversification benefits of including international stocks in a portfolio should not be overlooked.

The performance of the S&P 500 over the past decade has been outstanding. The concept of US exceptionalism is real. Robust capital markets, technological innovation, labor flexibility, and significant fiscal stimulus have contributed to exceptional economic growth and equity market performance. This has also led to record concentration levels in the S&P 500.

Increasing concentration in the S&P 500 poses significant risks for investors seeking diversification. Investors can reduce risk and improve diversification in their portfolios by considering alternatives such as equal-weighted S&P 500 ETFs, small-cap ETFs and diversified international large-cap ETFs. Even Warren Buffett would agree.