The illusion of diversification: What’s actually included in an S&P 500 ETF?

June 16, 20225 min read
The illusion of diversification: What’s actually included in an S&P 500 ETF?
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Key takeaways:

  • The SPDR S&P 500 ETF Trust (SPY) is a tradeable fund that tracks the popular S&P 500 index. It allows investors to easily buy into the entire inventory of the S&P 500 at a relatively accessible entry point.
  • The S&P 500 is heavily weighted toward large cap, growth-based companies, primarily from the tech sector, which challenges the idea that funds like SPY can help diversify a portfolio.
  • In a broadly diversified portfolio, the variety of asset classes is what hedges against volatility in the broader market.

Investors who believe they’re diversifying with index funds might want to think again. The SPDR S&P 500 ETF Trust (also known as SPY), which tracks the S&P 500 index, is a perfect example of a popular fund that allows for broad market exposure but offers limited diversification. By investing in SPY, investors can tap into the entire inventory of the S&P 500 index, eliminating the need to pick and choose individual stocks. But secular changes over the years have led to a concentration in the type of stocks these indexes represent. Today, the S&P 500 is heavily weighted toward large cap, growth-based companies – with technology as the leading sector–which means the S&P 500 index has become increasingly sensitive to economic volatility (i.e., rising interest rates). In a broadly diversified portfolio, the variety of asset classes is what can potentially protect against market volatility.

The S&P 500 and SPY

The S&P 500 (short for Standard & Poor’s 500) Index is one of the main equity benchmarks and it’s often used as a proxy for US equity markets . Made up of 500 large-cap U.S. stocks, the index is weighted, meaning it assigns a “weight” to each individual stock based on the market size of the corresponding entity. A designated committee maintains the 500 count, choosing and eliminating companies based on liquidity, industry and market capitalization.Exchange traded funds (ETFs) that track indices like the  S&P 500 provide a way for investors to gain exposure to the entire index at a relatively accessible entry point and at low fees.

The SPY ETF is just one example – it’s a tradeable fund that fully replicates the S&P 500 Index, holding all members of the underlying index at their target weights.

The era of tech

Buying SPY shares offers limited downside protection for investors in case there’s an economic downturn or a bearish market. Also, because of the way S&P 500 is set up, undervalued stocks can sometimes increase in weight before the index adjusts. 

Diversification, which is presented as a benefit to index investing, can also be narrower with SPY. Though the S&P 500 includes companies from different industries, which theoretically should diversify a portfolio (by industry, at least) recent trends are challenging whether it truly does.

As of June 2022, the Information Technology sector makes up over a quarter (26%) of the SPY ETF, followed by Healthcare at 14.4%. Drilling down further, the top 5 companies in the index make up over 15% of the total weight. These companies are all in Information Technology: Apple (6.4%), Microsoft (5.7%), Amazon (2.9%), Google parent company Alphabet class A and C shares (combined 3.9%), and Tesla (1.8%). 

The current composition of the index is a result of the way these businesses are valued and the way S&P chooses its stocks. In the last decade, the top 5 companies and the tech sector in general outperformed many other industries and grew their market cap levels to unprecedented highs, which translated into more weight in the index. The expectation for them is that they will keep growing, even if it’s at the expense of existing, more stable industries. This is why top performing tech sector companies have come to be known as “growth stocks.”

Growth stocks can skew the performance of the S&P 500 index toward higher risk equities. In times of market disturbance for example, these companies can be quick to react and their combined weight in the index might in turn have the power to move the S&P 500. Because it’s so strongly correlated to a single, volatile industry, the benchmark itself becomes more sensitive to volatility. In fact, amid the ongoing interest hikes now, the S&P 500 Index has declined over 20% year-to-date, with tech and growth stocks driving underperformance. 

Broader is better

Even if the S&P 500 were to reshuffle its selection of stocks to somehow exclude growth stocks, SPY can at best offer diversification by industry – a very limited scope when considering events like a war or a pandemic, which can affect all industries. 

Nobel Prize-winning American economist Harry Markowitz knew this and advocated for broad diversification instead. Portfolio optimization theory which was proposed by Markowitz in 1927 laid the foundation for modern portfolio theory (MPT), a mathematical framework for diversifying a portfolio by choosing an optimal spread of assets. It’s widely recognized today that Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing return. 

MPT is integral to sophisticated investor strategies today. Akin to the idiom “the whole is greater than the sum of its parts”, it advocates for curating a portfolio that maximizes return for a given level of risk. It also centers on broad diversification and choosing asset groups with little correlation. 

Yieldstreet and diversification

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