The news that Tesla (TSLA) is entering the S&P 500 left me triply entertained. First, I hadn’t realised that Tesla was not already in the index. Second, the announcement served as a reminder that the S&P 500 is a strange construction, being neither a pure representation of the largest US stocks nor a “strategic-beta” benchmark that aims to outgain the norm. It is mostly the former, with a splash of the latter. And third, Tesla’s stock immediately jumped 13% on the announcement it would be included in the index, which makes no sense, because Standard & Poor’s decision was inevitable. If not this month, then next month.
Larger at the Top
The addition of Tesla will increase the S&P 500’s concentration, which is saying a great deal, because it is already more top-heavy than at any other time during the past 25 years. Usually, the S&P 500’s top 10 holdings make up about 20% of the index’s total assets but that figure has expanded sharply over the past 18 months, reaching 28% in June. Since then, the top 10 holdings have surged even further and counting Tesla’s addition, now account for 34% of the index.
As indicated by the chart above, most of the growth in the top 10’s influence comes from strong performance from the index leaders - Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL), and Facebook (FB) - rather than from the addition of Tesla.
For several years, market observers have complained that the S&P 500 is dominated by a few giant holdings, but until recently such complaints were largely unfounded. From 2016 through 2018, when such comments started to become commonplace, the percentage of index assets occupied by the S&P 500’s top 10 continued to hover near 20%.
However, the argument certainly applies today. At one third of the S&P 500, the top 10 positions can now truly drive the index’s results. That condition has benefited S&P 500 index-fund shareholders in 2020 but whether it will continue to do so is, of course, another matter entirely.
Nowhere to Run
Switching from the S&P 500 to a fund based on a broader index ameliorates the issue, but it does not eliminate it. As the S&P 500 accounts for three-quarters of the value of publicly traded US companies, those same top 10 firms account for roughly 25% of the Wilshire 5000 and any other index that attempts to capture the entire American stock market. The condition cannot be escaped by purchasing, say, Vanguard Total Stock Market ETF (VTI) instead of Vanguard 500 Index (VFINX).
None of this would matter if the index’s biggest companies operated in unrelated businesses. If, for example, one firm was the world’s largest food manufacturer, one a multinational bank, another a pharmaceuticals giant, and a fourth the dominant chip manufacturer, then the index’s top positions would be diversified. To be sure, they would all fall together during a global stockmarket decline, but so would the rest of the S&P 500.
But that is not the case. Although Apple, Microsoft (MSFT), Amazon, Alphabet, Facebook, and Tesla would seem at first glance to occupy different industries, from building smartphones to installing software to delivering packages to manufacturing automobiles. In reality, their stock market valuations all depend upon two features: 1) preserving their semi-monopolies and 2) extending their technological advantages. They rise and fall on the same investment waves.
Buyer Beware
This same argument, of course, applied to tech stocks in the late 1990s. They initially appreciated in unison, and then collapsed as a unit. However, the comparison ultimately fails, because the current version of the S&P 500 is much more concentrated than its predecessor.
In summer 1999, four youngish companies (Microsoft, Cisco CSCO, Lucent, and Intel INTC) qualified for the S&P 500’s top 10. Collectively, they accounted for 11% of the index’s total assets. In contrast, the Sainted Six now make up 28% of the index. (Or 22%, if we eliminate Microsoft from the list, on the grounds that it has graduated to middle age.)
This column is couched with warnings: The possibility exists that what has occurred will reverse, thereby delivering losses to S&P 500 investors, even as most of their holdings appreciate. That caution is appropriate. Investors should realise that S&P 500 tracker funds have entered unchartered territory and their key characteristics have changed dramatically over the past few years. What’s more, the last time the index exhibited such behaviour, even faintly, that dance ended badly.
Also, the Sainted Six’s allocation punches above its weight. Aside from Tesla, these companies are consistently profitable; the health of their businesses is not in question. However, high investor expectations, along with the uncertainty associated with technology operations, make their stocks volatile. In practice, that 28% weighting sometimes moves so sharply as to dominate the proceedings.
None of this is to argue against owning an S&P 500 fund or other market-cap-weighted investment. Strong companies justifiably earn high valuations, and unless those prices are so steep as to be clearly ridiculous--which, in my view, they are not--it’s unwise to challenge the wisdom of the crowd. Just recognise that the index has changed: it is riskier today than in years past.
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