Although the start to 2022 by stocks is among the worst on record, concentration risk remains elevated in the cap-weighted S&P 500, other broad market indexes that are also cap-weighted, and the related exchange traded funds.
For example, Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) combined for 12.76% of the S&P 500 entering Monday, and that’s with the Nasdaq-100 (NDX), which is also cap-weighted and home to those two technology giants, now in a bear market for the first time since March 2020.
“There are many ways to measure concentration. A simple method is to add up the weight of the top names, but the drawback with this approach is it doesn’t incorporate all the constituents in an index. The Herfindahl-Hirschman Index, defined as the sum of the squared index constituents’ percentage weights, is more favorable from this aspect and is widely used,” notes S&P Dow Jones Indices.
Among ETFs, one of the most efficient avenues for combating concentration risk while maintaining broader domestic equity exposure is with the Invesco S&P 500® Equal Weight ETF (RSP ).
RSP, the largest ETF of its kind, follows the S&P 500® Equal Weight Index. As its name implies, that index is the equal-weight counterpart to the cap-weighted S&P 500.
“But the HHI faces an issue, which is that even for completely unconcentrated equal weight portfolios, the HHI value is inversely related to the number of names. If we want to use the HHI to examine the history of concentration within an index or to make cross-sector comparisons, we need to adjust for the number of names,” according to S&P Dow Jones.
In other words, that way of measuring concentration risk may not always reflect that concentration in a sector increased simply because the number of constituents in that group decreased. Bottom line: RSP remains an effective avenue for employing legitimate equity diversification in portfolios.
Consider the following: Nine of RSP’s top 10 holdings are either oil companies or fertilizer producers, which are two of the hottest corners of the market this year. Despite the fact that stocks in those sectors are soaring, RSP’s largest component, Occidental Petroleum (NYSE:OXY), commands a weight of just 0.40% in the fund.
RSP’s methodology is working, as highlighted by the fact that the equal-weight ETF is beating the cap-weighted S&P 500 by 343 basis points year-to-date.
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