As equity markets hit new highs, there are a couple of questions we see coming up more frequently: Are the indexes becoming too concentrated? Could this trigger or result in bigger losses when markets eventually falter?

Talk of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google – including Alphabet) has been rampant in the last few years. These five firms have powered a significant portion of US equity market gains since mid-2016. In fact, if we add Microsoft to the list, these six stocks alone have generated nearly a third of the gains in the S&P 500® for the two-year period from July 1, 2016 to June 30, 2018: 10.2% for the FAANGs + Microsoft vs. 34.8% for the entire index.1 Put in sharper focus, these six names have contributed nearly 30% of the return while comprising only 13% of the market cap of the index – effectively punching above their weight by over a 2:1 margin.

This may sound impressive, but it’s just the mathematical result of what happens when the largest mega-cap stocks significantly outperform the rest of the index. Similarly, this fact alone doesn’t necessarily mean that the indexes are becoming more concentrated. To assess this, we’ll look at three more specific metrics.

Crunching the Numbers
First we’ll measure index concentration based on the cumulative weight in the top 10, 25, and 50 stocks annually, going back to 1999. See chart below.

S&P 500®: Weight in the Top Stocks
Source: Bloomberg, Natixis Investment Strategies Group, Dec. 1999 – June 2018

Alternatively, we could measure the number of stocks that constitute the top 50% of the index by weight. This tells a similar story (right scale below).

S&P 500®: Index Concentration
Source: Bloomberg, Natixis Investment Strategies Group, Dec. 1999 – June 2018

While intuitive, neither of these measures fully accounts for concentration across the whole index, as each stops at a defined point. To remedy this, we can borrow a concentration metric from industry analysis called the Herfindahl-Hirschman Index, or HHI. The HHI squares the weight of each component (in our case, the stocks in the S&P 500®) and adds them up. The squaring simply puts proportionally more weight on larger components (or in our case, index constituents). We have added the HHI to the chart above.

While the HHI was developed to assess industry concentration for antitrust, M&A, and competitive applications, the basic math serves the same purpose. A higher HHI implies a higher concentration of the constituents.

The Verdict on Index Concentration
Note that while the HHI measures concentration across the entire index, it tells very much the same story as the first two metrics (cumulative weights in the top 10/25/50 stocks and the numbers of stocks to reach 50%). This is hardly a surprise as concentration is dominated, by definition, by the companies at the top of the index. Is the S&P 500® becoming more concentrated? Yes and no. More recently, there is a clear trend: Since 2014, the index has become increasingly more concentrated – most notably with a significant jump in the HHI in 2018 (through June 30). How much more concentrated? Roughly 25% more as measured by the HHI and the cumulative weight of the top 10 names. However, looking at the entire series from 1999, the index today is actually less concentrated, by all measures, than it was at the peak of the tech and telecom bubble. In fact, the HHI is 25% lower today versus 1999.

A General Observation
Even so, this analysis misses a more subtle point about industry concentration. In 1999, the market cap of technology stocks in the top 20 holdings was 17.1%, comprising 8 stocks. Today, the top 20 includes only 7 tech names but makes up the same 17.1% of the index. By this estimate, we can say that the S&P 500® is every bit as tech-heavy today as it was at the peak of the tech bubble. So why was the index so much more top-heavy in 1999, despite roughly the same tech weight in the top 20 names as today? One name – General Electric Company (GE) – which made up 4.9% of the index in 1999 but only 0.5% today.

Bulls and Bears, Ups and Downs
What will remedy this situation and reduce the overall concentration of the index? Again, the charts are fairly consistent – a good ole-fashioned bear market! As the charts show, concentration rises into market peaks (1999, 2007, 2018…) and then falls into selloffs (2000–2001, 2008–2009). This again should come as no surprise. Index returns in cap-weighted indexes are dominated by the biggest names.

By definition, the contribution to return in a strong bull market must be led by those names, resulting in more concentration at the top. The contribution to losses in a significant selloff must also be led by the biggest index names, naturally resulting in less concentration at the top. To be clear, this is not a causal relationship – high concentration doesn’t cause a selloff, nor does low concentration cause a rally. We’re simply noting that strong bull markets, as we’re experiencing now, are naturally associated with growing index concentration.

The Harder They (Probably) Fall
Investors might be curious: If cap-weighted indexes like the S&P 500® have become more concentrated in the last few years, and more money is flowing into these passive cap-weighted strategies, will this trend produce greater losses when the next bear market eventually hits?

As others have noted, the money now flowing into passive cap-weighted indexes might otherwise have gone into actively managed equity strategies buying the same stocks. In that sense, the active vs. passive distinction isn’t creating more concentration. However, the idea that passive flows would have gone into actively managed portfolios investing in the same stocks at the same weights may not be completely accurate. A quick analysis using portfolio data from Morningstar Direct® shows that among actively managed funds in the Large Blend Morningstar® category,2 less than 20% have an average market cap weighting greater than the S&P 500®. The numbers are similar if you use Morningstar’s market cap “Size Score".3 Simply put, more than 80% of these actively managed funds are run “smaller” than the index. This of course makes sense because it is very unlikely that the majority of active managers would be overweight all the biggest stocks in the index – i.e., those that have already done the best.

This potentially indicates that actively managed funds typically aren’t quite as top-heavy as the major market cap-weighted index strategies. From this, it naturally follows that the growth in equity indexing is, at the margin, making the market somewhat more top-heavy.

Does this mean the next bear market will be worse than it would have otherwise been because of the growth in indexing? Yes, probably. However, this would be impossible to know with certainty in advance and it’s doubtful investors will notice the difference in retrospect.
1 Source: Bloomberg

2 The Large Blend Morningstar® category contains funds that are fairly representative of the overall U.S. stock market in size, growth rates, and price. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large-cap. The blend style is assigned to funds where neither growth nor value characteristics predominate. These funds tend to invest across the spectrum of U.S. industries, and owing to their broad exposure, the funds' returns are often similar to those of the S&P 500® Index.

Rather than using a fixed number of "large-cap" or "small-cap" stocks, the Morningstar Size Score uses a flexible system that isn't adversely affected by overall movements in the market. World equity markets are first divided into seven style zones: United States, Latin America, Canada, Europe (includes Africa), Japan, Asia ex-Japan, and Australia/New Zealand. The stocks in each style zone are further subdivided into size groups. Giant-cap stocks are defined as those that account for the top 40% of the capitalization of each style zone; large-cap stocks represent the next 30%; mid-cap stocks represent the next 20%; small-cap stocks represent the next 7%; micro-cap stocks represent the smallest 3%. For value-growth scoring, giant-cap stocks are included with the large-cap group for that style zone, and micro-caps are scored against the small-cap group for that style zone.

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