The S&P 500, which is short for Standard & Poor’s 500, is the world’s most widely used stock market index. It was introduced in 1957 to track the value of 500 companies that had their stocks listed on the New York Stock Exchange (NYSE) and NASDAQ Composite.
The exact combination and weighting of various constituents within the S&P 500 are adjusted as the economy changes. The S&P is widely considered a bellwether indicator of the US economy. Its performance has also shown how the country’s financial markets are performing.
The S&P 500 has changed quite a bit over the years as far as the companies that make it up. Most recently it has been dominated by a few companies in the tech industry. The technology sector initial composite included Google parent Alphabet, Facebook (Meta), Amazon, Microsoft and Apple. Since 2020, the S&P also includes Tesla to this list of tech companies.
Since Tesla joined in 2020, the market share of tech in the S&P has gone up quite significantly. With the addition of Tesla the big six now add up to 40% of the market-capitalization-weighted index, according to a DataTrek Research. No other broad market index around the world has a 24 percent weight to its top 6 names.
Nicholas Colas, co-founder of DataTrek, says, “We’ve halfway joked since starting DataTrek that ‘Tech’ would eventually be 50 percent of the S&P 500 but thought that was maybe a 2030 event. The way things are going, it will come long before that.
The boom of these tech companies in the stock market was driven by their unique influence into our daily lives. Technology shapes how we work, communicate, shop, and even relax now. The pandemic has only increased this as people were spending more and more time online.
These companies received a larger share of spending in the economy and greatly increased their profits during this time. The pandemic has sent investors rushing to these stocks as other companies are struggling to survive. They are betting that the position of these tech stocks will be unassailable for years.
There are several reasons why this dominance of the tech sector could be concerning. The main of which is that it is creating a highly concentrated market. This can raise alarms for investors that want to minimize risk. Especially since several of these companies, Tesla included are far from being mature and stable companies.
One of the big drawbacks to the S&P 500 is that the index gives higher weights to organizations with more market capitalization. What this means is that companies like Tesla and Google have a higher influence on the index than a company with a lower market cap. Small-cap companies that will generally earn higher returns aren’t afforded any exposure in the S&P 500 index.
The S&P 500 finished 2020 up 16% due to the fact that the index is market-cap weighted. This can be misleading though. If you weighted the rest of the companies in the S&P 500 equally last year, the market would have only rose 10%.
A professor of Quantitative Finance at Stevens Institute of Technology, George Calhoun, claims “This is a concern. Tesla is exacerbating the overweighting of tech stocks. They have driven the gains for the market inordinately.”
It’s important to understand that even though the big tech companies helped improve the market, that there were over 200 companies in the S&P 500 that finished 2020 in the red. Many experts believe that these numbers are unsustainable. As history has shown us this before and that it is likely to end poorly.
Many experts believe that the tech bubble will eventually burst. When comparing it to other market crashes, the elements of extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior will eventually lead to this bubble bursting as well.
The concentration in the tech industry today is greater than what it was that in the late 1800s. This was when Congress passed an antitrust legislation to help curb the power of the railroads. Additional antitrust laws were added in 1936 after Sears and A&P accounted for 3% of retail sales. These numbers seem miniscule when comparing to companies like Amazon or Walmart today which account for 15% of retail sales.
Owning a concentrated stock position can present significant risk if not managed correctly. Most investors understand this risk but finding ways to mitigate it is no easy task. Although it’s not easy to eliminate this risk there are techniques available that can help investors preserve their portfolios for the long-term.
This can often be a challenging task, as there are many hurdles to get over. Typically, these hurdles will include regulatory constraints and tax consequences.
The first option would be an immediate sell. This is the most direct solution and eliminates the risk immediately and you can then reinvest into a diversified portfolio. The main risk here is you could miss out of potential earnings of that individual stock.
Another option is staged selling which is done by taking a large portion of that stock and slowly converting that concentrated equity into a diversified portfolio. This will allow the investor to still hit the upside growth of the concentrated stock as the advisor can figure out what other positions are best for your portfolio. The capital gains liability will also get spread out if this is done across multiple tax years.
A good financial advisor can also customize an investor’s portfolio construction to help diminish the risk of being in a concentrated stock. For example, your advisor can prevent further investing in a company that you already have a concentrated stock position. If this concentrated stock is connected to a specific industry or market cap segment, an advisor can take steps to avoid strategies that would invest in these types of industries or segments. An advisor may try adjusting weighting to an asset that is not associated with these industries or segments to help eliminate risk.
Hedging is another strategy for investors who don’t want to drop their concentrated position. There are several choices when it comes to hedging your position, but it allows the investor to protect your position if the volatility of the stock gets too crazy.
For certain qualified investors, an exchange fund is another option to handle a concentrated stock position. Exchange funds allow an investor to diversify their portfolio while deferring capital gains taxes. The downside with this strategy is the investor has to hold onto their shares of the new diversified portfolio for a set number of years and this process can usually entail high fees.
One final option to get out of a concentrated stock option is a charitable gift or wealth transfer plan. By having this type of strategy in place, it can lessen the capital tax gains on the stockholder and help reduce the concentration risk by allowing the stockholder to make a charitable deduction.
There are several options on how to handle a concentrated stock position. Which one works best will depend on the investor’s unique situation. It might be time to consider a change in strategy if you find yourself holding onto a concentrated stock. We’re here to answer any questions on how the tech sector has dominated the S&P these last couple of years or how to best diversify from a concentrated stock.
