Single stock concentration. The problem with cap-weighted indices—meaning the stock carrying the largest percentage ownership in the index is the one with the biggest market capitalization—is that they are vulnerable to concentration. As a company increases in value, so, too, does its weight in the index. This, in turn, means the index's performance is more greatly influenced by this stock.
Sector risk. Another problem is that an index can become susceptible to sectors that are growing in value. As of Dec. 31, 2010, the technology, financial, and energy sectors make up just shy of 50 percent of the total S&P 500. If an investor desires a well-diversified portfolio, but is benchmarking against the S&P 500, they may be disappointed in their performance if tech, financials, and energy go on a tear—causing them to take on more risk in the interest of keeping up with the S&P 500.
Style risk. Finally, the same thing happens if a certain style starts to outperform, such as growth versus value stocks. As with the sectors above, the same concentration risk can result with styles.
One tool that investors have at their disposal is the ability to track—and invest in vehicles that track—the performance of equal-weighted indices. An equal-weighted S&P 500 index is a good example.
As of Dec 31, 2010, the stock with the largest position in the S&P 500 was 3.23 percent. In the equal-weighted S&P 500 index, that same stock has a weighting of just 0.2 percent. This eliminates issues with concentration and reduces the effect of "compounding the effects," such as one stock with a large market cap, in an over-weighted sector in an outperforming style.
David B. Armstrong , CFA, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010 based on assets under management) and has been interviewed by several national media sources over the past several years. David and Monument Wealth Management can be followed on their blog Off The Wall, their Twitter account @MonumentWealth, and on their Facebook page.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The S&P 500 index is an unmanaged index and cannot be invested into directly. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. International investing involves special risks not associated with investing solely in the United States, such as currency fluctuation, political risk differences in accounting and the limited availability of information, and may not be suitable for all investors.
Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.