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Just seven companies have kept the S&P 500 Index afloat this year, with Apple, Meta, Microsoft, NVIDIA, Amazon, Alphabet and Tesla driving the vast majority of gains. Stretched valuations are also a concern for some investors: while not as wide as recent history, current forward price-to-earnings ratio on the top 20 stocks in the S&P 500 are roughly 42% higher than the overall market.

In terms of index concentration, Apple and Microsoft stand out with weights of 7.7% and 6.8%, respectively, as of 30 June — more than double that of Alphabet, the third-largest holding, at 3.6%. This dynamic is self-reinforcing. Higher stock prices can fuel market capitalisation gains and index recalculations, which in turn fuel additional inflows to these stocks as millions of investors in passive funds make their regular contributions under defined contribution plans, perpetuating the cycle.

This “bad breadth” is challenging the industry in a way that hasn’t been seen in roughly 40 years. The Nasdaq 100 Index underwent a “special rebalance” in late July for only the third time in its history to address over-concentration and avoid breaching Securities and Exchange Commission rules on fund diversification. In a related action tied to regulatory guidelines, some of the largest US investment funds are being blocked from buying more shares of these companies.

And it’s challenging for end investors in unexpected ways. For one, there is evidence this situation can increase overall portfolio risk, especially for passive investors. It is made worse by the business similarities of the companies leading the market higher — magnifying concentration risk. But there are few steps investors can take to help mitigate the risk.

One doesn’t need to be a professional equity analyst to understand that these seven companies have more in common than not. All are exposed, in various ways, to secular trends like the rapid evolution of artificial intelligence (AI) applications, augmented reality/virtual reality, autonomous vehicles and more. Zooming out, the top 20 stocks in the S&P 500 are dominated by two sectors (communication services and information technology). Sectors excluded entirely include materials, utilities and real estate.

This overlap means that despite their unique businesses and idiosyncratic characteristics, a large part of their return potential will be based on common risk factors. In comparing the risks unique to the company (security-specific risks), the top 10 or 20 stocks versus the broader S&P 500 Index are less diversified as they are more concentrated in certain sectors. Thus, the diversification benefit offered by holding these specific stocks — alone or within a passive, indexed strategy — is greatly diminished.

When an index loses its lustre

Another useful way to look at the increasing narrowness of the US equity market is through a measure that antitrust regulators use to gauge market concentration within an industry, the Herfindahl-Hirschman Index (HHI). The index allows us to answer the following hypothetical: Let’s say you wanted to create an equally weighted portfolio of stocks that would provide the same level of diversification as the market-cap weighted S&P 500 Index. How many stocks would there be in that hypothetical portfolio? This number is called the “effective number of constituents” (ENC) in an index, an inverse of the HHI. The answer is 60 stocks (as of 30 June, 2023). Because the S&P 500 Index  is so highly concentrated, it isn’t providing any more diversification than a portfolio of 60 equally weighted stocks, according to the HHI measure.

Diversification disappointment grows

If it weren’t enough that the diversification power of the equity portion of many investor portfolios had eroded, the diversification typically achieved with a bond allocation is somewhat diminished as well. Since December 2012, over rolling 90-day periods, higher market concentration was associated with higher correlations between stocks and bonds. That is, stocks and bonds tended to move more in unison and, as a result, the overall diversification benefit of a typical mixed asset portfolio was reduced on the margin.

As a result, should markets turn lower, investors could be hit with a less diversified equity investment.

Narrow market rallies tend to widen over time

To be clear, the situation is far from dire, and there is some evidence that narrow market rallies have often been followed by steady gains for the broader market. However, investors must consider that should euphoria over AI subside, a pullback in tech stocks could stifle a broader rally. As of 30 June, nearly all 11 sectors in the S&P 500 generated positive results for the quarter to date, but the price-to-earnings ratio for the S&P 500 technology sector was 27.1 times earnings as of 30 June, compared with 18.9 times earnings for the broader S&P 500