One of the best aspects of investing is that there are a variety of ways to build wealth on Wall Street. If you're a growth-seeking investor, there are ample pathways to make money. Meanwhile, if you're a conservative investor who prefers to put money to work in brand-name businesses, plenty of individual stocks and exchange-traded funds (ETFs) cater to this strategy.
Investors can also make money by concentrating their portfolio into a few top-tier ideas, just like billionaire Warren Buffett, or by diversifying their invested assets across dozens or hundreds of individual stocks.
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One of the more popular ways of achieving a diversified portfolio is through index fund investing. Buying ETFs that track the major indexes allow investors to gain exposure to all components within an index with the click of a button. Examples include these ETFs:
- SPDR Dow Jones Industrial Average ETF Trust (DIA 0.36%), which attempts to mirror the performance of the Dow Jones Industrial Average (^DJI 0.40%)
- SPDR S&P 500 ETF Trust (SPY 0.95%) or Vanguard S&P 500 ETF (VOO 1.00%), which both attempt to mirror the benchmark S&P 500 (^GSPC 1.02%); and
- Invesco QQQ Trust (QQQ 1.54%), which follows the performance of the Nasdaq 100. The Nasdaq 100 comprises the 100 largest nonfinancial companies listed on the Nasdaq exchange.
While instant diversification has been common with these indexes and ETFs in the past, it's not something you're going to find today. Right now, the Dow, S&P 500, and Nasdaq 100 represent highly concentrated bets on the health of an increasingly smaller number of businesses.
Eight components account for nearly 56% of the Nasdaq 100's weighting
The Nasdaq 100 is the perfect example of an index that's anything but diversified. Out of its 101 components (one company has two classes of shares; thus, 101 components and not 100), eight accounted for 55.51% of the total weighting of the index, as of the closing bell on July 6, 2023.
In order, these eight components are:
- Microsoft:13.023% weighting
- Apple: 12.505%
- Nvidia: 6.953%
- Amazon: 6.787%
- Tesla: 4.517%
- Meta Platforms: 4.319%
- Alphabet: Class A shares 3.748%/Class C shares 3.661%
In other words, the Nasdaq 100 has effectively become a megacap growth stock tracking index and nothing more.
The S&P 500's concentration is its highest in decades
It's a similar story for the broad-based S&P 500, which has 500 representative companies and 503 components. You would think that having 500 companies weighing in on the movements of the S&P 500 would provide unmatched diversification and offer a clear picture of the health of the U.S. stock market. However, this couldn't be further from the truth at the moment.
As of July 6, eight megacap stocks (and nine total components) accounted for almost 30% of the weighting of the S&P 500. In order, these companies are:
- Apple: 7.696213% weighting
- Microsoft: 6.886147%
- Amazon: 3.109543%
- Nvidia: 2.825827%
- Tesla: 2.021879%
- Alphabet (Class A, GOOGL): 1.936527%
- Meta Platforms: 1.75294%
- Alphabet (Class C, GOOG): 1.677152%
- Berkshire Hathaway: 1.652536%
According to a recent research report from Morgan Stanley, the top 10 largest components of the S&P 500 have averaged around a 20% weighting over the past 35 years. The current top 10 pushes close to a 31% concentration, which would be nearly 6 percentage points higher than during the dot-com bubble in 1999-2000.
A third of the Dow's weighting relies on five stocks
Investors aren't going to find the diversification they're looking for with the ageless Dow Jones Industrial Average, either. Whereas the S&P 500 and Nasdaq 100 are market cap-weighted indexes, the Dow is share price-weighted. In other words, a higher share price is all that matters within the Dow.
As of July 6, five of the Dow's 30 multinational components accounted for 33.4% of its weighting. In order, these five components are:
- UnitedHealth Group: 9.116037% weighting
- Microsoft: 6.628238%
- Goldman Sachs: 6.079171%
- Home Depot: 5.865914%
- McDonald's: 5.728016%
Being a share price-weighted index means smaller businesses can have an outsized impact. For instance, Goldman Sachs has a $105 billion market cap and a $315 share price. Apple has a $3 trillion market cap, but "only" a $191 share price. As a result, Goldman Sachs has considerably more influence over the Dow's moves than Apple. This is something of a double whammy for investors wanting diversification.
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Two ETFs that offer true diversification right now
Buying the SPDR Dow Jones Industrial Average ETF Trust, SPDR S&P 500 ETF Trust, Vanguard S&P 500 ETF, and Invesco QQQ Trust simply won't provide investors the true diversification they're looking for at the moment. Thankfully, two other ETFs can fit the bill.
The first well-diversified ETF to consider is the Vanguard Total World Stock Index ETF (VT 0.90%), which has $36.4 billion in net assets and has spread these assets across 9,536 stocks around the world. The nine largest components of the Vanguard Total World Stock Index ETF, which are the same as the S&P 500, albeit in a different order, come to just 14.75% the weighting of the total fund. This is an ETF that allows investors to take advantage of domestic and emerging market growth for a minuscule net expense ratio of 0.07%.
The second well-diversified ETF to buy if you crave diversification is the Invesco S&P 500 Equal Weight ETF (RSP 0.05%). Whereas the S&P 500 is market cap-weighted, this ETF effectively places an equal weighting on all the S&P 500's components. This means all 500 companies can more or less equally move the ETF, and not just a select few megacap growth stocks. The net expense ratio for the Invesco S&P 500 Equal Weight ETF is a reasonably low 0.20%.
History tells us that periods of high concentration for the S&P 500 tend to be short-lived. That's generally good news for investors who choose well-diversified ETFs, and potentially poor news (at least in the short run) for those believing they're getting top-notch diversification with tracking indexes of the Dow Jones, S&P 500, or Nasdaq 100 in today's market.
