The S&P 500 remains a benchmark index for equity investors, but recent trends mean investors must evaluate the kind of exposure the index offers their portfolios. Bill Nygren, CIO-U.S., portfolio manager, and Robert Bierig, portfolio manager, both of Harris l Oakmark, discussed hidden risks in the S&P 500 in a recent video.
“Most of the industry today is focused on tracking error as the main metric for determining how risky a portfolio is,” said Nygren. However, this doesn’t take into consideration the underlying risk in the index and may be misleading for investors.
According to Harris l Oakmark, the S&P 500’s risk profile grew in three specific areas over the last several years. These include concentration risk (across individual stocks as well as industries), style risk, and valuation risk.
Concentration Risk Embedded at the Individual & Industry Level
Concentration risk within the S&P 500 remains a hot topic and concern for investors. The top five constituents comprise nearly 30% (27.18%) of the index’s weight as of the beginning of September. This level of concentration by the top five constituents mirrors the index in 1957.
“At the time, those five names were General Motors, General Electric, Exxon, Dupont, and AT&T,” Nygren explained. “You can see that that ushered in almost a 40-year period of those names not being able to maintain their weighting in the S&P as other names in the S&P performed significantly better.”
However, a key differentiator between the current concentration in the index and that of 1957 is that the top five securities then represented a range of industries. Today, the top securities almost all belong to the information technology industry.
Know What You Own: Style Risk in the S&P 500
According to Morningstar’s categorization system, the S&P 500 historically oscillated in the middle ground between a value and growth classification. This entails assigning a Value-Growth Score to companies, with those under 100 classified as value and those above 200 deemed growth stocks. They then compile the broader index portfolio’s score based on index weightings. Portfolios with a score less than 125 are value portfolios, while those above 175 are growth.
Before last year, the index generally averaged around a 150 score. However, S&P 500 investors today now add concentrated growth exposure when adding the index to their portfolio.
“As growth stocks have performed so well in the past couple of years, we see… the chart go way up and to the right,” noted Nygren. “At the end of June, the S&P 500 Index fund had a 190 score on the Morningstar Growth-Value ratings.”
Valuation Risk Still Looms Large
Equity valuations remain significantly above historical levels, potentially impacting returns. The firm charted five-year annualized returns to the forward P/E ratio of the S&P 500 over the last 25 years. They found that when the forward price-to-earnings ratio was lower, the index generated better returns than when P/E was higher. What’s more, when P/E peaked at the highest levels (above 22.0x), returns became negative for five years.
“Based on history, the odds of a very strong performance from the S&P 500 for the next five years look relatively low,” Nygren explained.
For more news, information, and analysis, visit the Portfolio Construction Channel.
