The largest of the large cap stocks in the S&P 500 have delivered some of the index’s strongest gains over the past several years. As investors have continued to pour money into names such as Apple, Microsoft, Amazon, Alphabet and Facebook, the market capitalizations of these companies reached historically high levels. This, in turn, has pushed their weightings within the index markedly higher. As a result, the S&P 500 Index’s top 10 holdings currently hold greater sway over the index’s returns than even during the peak of the tech bubble in 2000. In fact, these top 10 stocks now represent 28% of the index’s weightings as of September 30, 2020 compared to 27% on August 31, 2000 (the peak weighting skew) and well-above the long-term monthly mean of 20% over the past 30 years.

This has created a sharp rise in capital concentration risk. The figure below shows the percentile ranks of capital concentration, a measure of how much capital is contained within the largest stocks.

As of the third quarter of 2020, capital concentration for the S&P 500 is in the historically high 90^th percentile based on index data stretching back to 1979. Of course, history suggests that capital flows tend to reverse course when this concentration pendulum swings too far in either direction. That’s not to say that a near-term reversal is necessarily imminent, but it does imply that at some point— probably sooner rather than later based on historical norms—the trend will once again begin to shift. (Check out the interactive Intech Equity Market Stress Monitor^® to see how some other major regional and style indexes are residing near the opposite end of the spectrum from the S&P 500).

So what might this mean for long-term investors? It is well documented that human behavior tends to place too much importance on recent events, while ignoring historical data. Consequently, some investors may have been lulled into a sense of complacency around their increased exposure—either directly or through traditional index investing—to the relatively small group of large cap names that have been the primary market drivers over the past few years.

It is easy to understand why some may have found it difficult to maintain a strict focus on the long-term benefits of rebalancing in this type of market, especially when the top stock performers have been on such a tear for so long. A “let it ride” strategy may work in investors’ favor short term. However, much like a gambling strategy based on “feel” and momentum, we believe that eventually reduced diversification will manifest in elevated drawdown exposures.

We consider the dramatic rise in capital concentration risk into larger cap stocks a probable warning sign for investors. Rebalancing can offer an effective way to help manage this concentration risk and tap into potential added alpha through an investment concept known as the excess growth rate. This cornerstone of Intech’s investment process refers to the mathematical difference between a portfolio’s variance and the weighted stock variance of its individual assets, directly quantifying the contribution to portfolio return due to diversification.¹

Reversion to the Mean: A Historical Perspective

U.S. equity markets may continue to be dominated by this handful of large cap stocks for the foreseeable future. No one really knows what the future may hold. Still, history has shown two extremely consistent trends to consider:

1) Capital distribution has been remarkably stable over time. The capital distribution chart below shows the curve of the S&P 500 Index, illustrating the capitalization weights of stocks and their capitalization ranks from largest to smallest. This distribution has been very stable from decade to decade, with the largest stocks in the index tending to represent similar capitalization weights over time. The same has held true down to the smallest stocks as well. It is true that the steepness of this curve has varied more across shorter time periods, due to shorter-term shifts in large cap/small cap relative outperformance. Nevertheless, over the long term, these variances have consistently returned to a more stabilized norm, even with some of the major changes in equity investing over the past 50 years, such as computers, the internet, globalization, high-frequency trading, ETFs, passive investing, etc.

2) The index’s largest stocks have also consistently changed. It may be hard for less experienced investors to imagine a market that is not ruled by today’s technology titans, but the reality is that even as relative individual stock weightings have remained fairly stable over the long term, the names of the stocks themselves have steadily changed through the years. This is shown in the table, which highlights the ten largest U.S. stocks in each of the years referenced above.

Importantly, a number of factors can disrupt these trends short term. The potential for monopolies, for example, could keep the current momentum going for a longer period. Even given these types of anomalies, though, history clearly indicates that deviations from long-term market averages tend to revert to the average over time. In addition, market leadership has tended to be impermanent.

While we may not know when stocks might revert and market leadership change, we remain highly confident they will at some point.

Explore an Evergreen Approach

U.S. equity capital shifted to the top in recent years, but it likely won’t last forever. We advocate for an approach to portfolio management – diversification and systematic rebalancing – that works over the full market cycle. Learn more in our latest paper, “Does Rebalancing Still Make Sense?”

¹A portfolio’s excess growth rate is computed using the formula: excess growth rate = ½(weighted stock variance – portfolio variance). Note that this is solely based on stocks’ weights, volatilities and correlations, as opposed to the average returns of stocks relative to each other. If the portfolio weights are not constant, the formula requires an appropriate average over time.
The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. An index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the active management of an actual portfolio.