Ways to Manage Mega Cap Concentration

If you looked just at the S&P 500^® Index—up about 16% for the year—you might think the "stock market" generally has been having a great run, notwithstanding the volatility spike in early August. However, that headline number obscures a lot of turnover among winners and losers as stocks take turns in the driver's seat.

The S&P 500 takes every public company listed in the U.S. and ranks the top 500 by their market capitalization, or the combined value of their outstanding shares. The resulting index gives more representation to stocks with the biggest market capitalizations, while smaller players get less. For example, mega caps Apple, Microsoft and Nvidia alone account for 20% of the S&P 500, while many smaller-capitalized companies account for 0.2% or less.

As a result, when big companies do exceptionally well, they can pull the entire index up with them, even if many of the other stocks on the index are struggling. That has been the situation for much of this year, with big tech companies leading the way.

This might not sound like much of a problem—as long as the index is up, that's a good thing, right? And why would you want more exposure to laggards anyway?

Think of it this way: An index, like a portfolio, is a collection of securities, and the more its fortunes are concentrated on just a few big stars, the greater the potential impact of a sudden reversal.

Plus, past performance is no guarantee of future results. Recent weeks have already featured some pretty heavy rotation of money away from the top of the index, as concerns about tech earnings and concentration risk have grown, while the prospect of rate cuts has raised the appeal of smaller companies.

So, if your portfolio relies heavily on market-cap-weighted index strategies, what can you do to protect yourself when giants are dominating the field? In a word, diversify.

Market cap strategies have a place in many portfolios, but they aren't the only way to sort and select investments. Other approaches can offer complementary benefits, while ensuring you still reap some of the gains when the big guys are surging. Here are some possibilities to consider.

Instead of ranking stocks by market value, so-called strategic beta strategies select and weight stocks according to other factors. For example, equal weight-indexing strategies give every stock equal representation on the index, so on an equally weighted index of 500 companies, each would account for 0.2% (1/500) of the total index.

Fundamental indexes, on the other hand, weight companies based on accounting factors, such as sales, cash flow, and dividends plus buybacks. So, a company that generates significant operating cash flow would typically represent a larger portion of a fundamentally weighted index than a firm with little operating cash flow.

Low-volatility indexes weight stocks based on their level of historical or predicted volatility over a specified period, so that the least volatile stocks over a given period have the biggest weightings; while momentum indexes weight stocks based on their price momentum over a specified period, so the fastest risers get top billing.

Because of these differences, alternative weighting strategies tend to behave differently than market cap-weighted indexes in a given market scenario.

Investors can also consider mixing traditional cap-weighted and other strategies.

Thematic strategies offer another way to organize and rank securities without reference to size or market cap. Thematic approaches are a bit like sector investing, because investing themes also group together companies and slices of the economy, but with a focus on ideas, personal values, or trends—especially new or potentially transformative technology or social forces—that don't fit squarely into the existing classifications.

As a result, thematic strategies can be both more targeted than sector-based ones, at least insofar as they focus on a particular idea or trend, and more broad-based, because they can consider stocks from any industry or sector, so long as they are relevant or consistent with the theme. Stocks are then ranked and weighted by thematic relevance, rather than market cap, with the most thematically relevant stocks having the most representation.

Such strategies might focus on emerging technology like AI, electric cars, or 3D printing, or attempt to invest in the interests of certain demographic groups or social changes such as aging societies. Think big, long-term structural forces with the potential to remake the economy.

Of course, thematic strategies that happen to include the same mega cap stocks that dominate the S&P 500 could increase your concentration risk, so make sure your theme balances your long-term vision with your appetite for risk.

Also, keep in mind that thematic relevance is more subjective than market cap. Every strategy will reflect the views of the research provider, so make sure you understand how and why certain stocks were selected before deploying a thematic strategy.

Speaking of human judgment, putting some of your portfolio in the hands of a financial professional manager by way of an actively managed fund can be another way to manage concentration risk. After all, professional management can shine during shifting market conditions. 

Actively managed funds typically aim to beat a target index by adjusting their portfolios in response to changing market environments. So, in cases where mega cap stocks start to look too dominant, an active manager might start to rotate their holdings as conditions shift.  

There are tradeoffs, though. First, active management tends to cost more that index-based or other rules-driven strategies. Also, there's no guarantee an active fund manager will make the right choices while adjusting their holdings. 

The elevator pitch for direct indexing might go something like this: performance and diversification like a regular index fund, but you can customize the holdings and harvest losses for tax efficiency.

This is possible because with these strategies you actually own all of the underlying stocks. So, for example, instead of buying an ETF tracking the S&P 500, you would hold a portfolio with a representative selection of the same stocks. (Note: It might not be all 500, but it would still be enough to mirror the index's performance.)

With ownership comes control, meaning you can make some of the strategic moves normally reserved for your stock holdings: Managing your exposure to certain companies or sectors by selectively excluding the biggest ones, say, or grabbing tax-loss opportunities by selling during market dips. (To be sure, there are limits to how much you can tweak such a portfolio before it stops performing like your target index.)

This kind of flexibility could help if you're already heavily exposed to the biggest companies through your regular cap-weighted funds. For example, if you invested in a direct indexing strategy, you could choose to limit your exposure to the biggest stocks to avoid concentration and duplication.

Keep in mind, though, that holding all those stocks requires a significant up-front investment, as you'll likely have to buy hundreds of individual stocks, in appropriate portions, to track your target index. Also, because these are actively managed strategies, direct-indexing portfolios come with higher fees than your average passively managed index fund.

Research by Schwab Chief Global Investment Strategist Jeffrey Kleintop has shown that different countries' stock markets have tended to mirror the performance of certain global stock sectors.

For example, in the U.S., the S&P 500 has tended to perform in line with the global technology sector (as measured by the MSCI World Technology Index), as you can see here.

France, meanwhile, tends to mirror the global industrials sector, while Australia tends to behave like materials, Canada like financials, and the United Kingdom like the energy sector.

So, if you're concerned about being overly exposed to the U.S.'s tech giants after their recent outperformance, you could consider diversifying across the globe.

Historically, it has been nearly impossible to predict which asset classes will perform best in a given year. Mega caps may have had a great first half, but there's no guarantee that will continue.

That's why we recommend holding variety of assets, in proportion to your goals and tolerance for risk. In fact, diversification is one of Schwab's seven Investing Principles. So, if you're concerned about being tied to a few giants, you have ways to broaden your reach.