The S&P 500 Doesn't Care About Diversification

The Problem - S&P 500 Doesn’t Care About Diversification

The S&P 500 ETF (SPY) might seem well-diversified at first glance, but it really doesn’t care about diversification. As a market cap-weighted index, the S&P 500 does the opposite of what many believe is best practice when it comes to investing—buying low and selling high. The S&P 500 buys more of a stock as it grows and sells the companies whose market cap shrinks. This approach can lead to extreme concentration when momentum is very strong. While this market cap-weighted approach doesn’t bother me, it can leave many investors unaware of the lack of diversification they are getting when buying the S&P 500. So what’s the solution? I like a counterintuitive approach.

The Solution - Buy Larger & Fewer Stocks

You could throw a rock in any direction and hit an article about buying small caps (IWM) but this strategy has its drawbacks. Small-cap stocks often come with lower-quality names and liquidity challenges. There is another solution: buy larger and fewer stocks.

The S&P 100 Equal Weight ETF (EQWL) tracks the top 100 stocks in the S&P 500 and equally weights them on a quarterly basis. This introduces a momentum factor, as it buys and sells stocks as they enter and exit the top 100 and a quality factor, as it’s only exposed to the 100 largest stocks in the S&P 500. It also imposes a ceiling on the momentum exposure by rebalancing the top 100 stocks back to equal weight each quarter. As a result, there are times, such as the present day, where owning 100 stocks provides more diversification than owning 500.

Sector Analysis - Nominal Diversification

As you can see below, due to the strength in technology over the past decade and the momentum approach of the S&P 500, technology has become the captain that steers the ship. The diversification is, in reality, only nominal. The S&P 100 Equal Weight (EQWL) eliminates that overly concentrated technology exposure by offering more exposure to Financials (XLF), Industrials (XLI), and Staples (XLP) while still focusing on the largest stocks.

The current narrative emphasizes buying small-cap stocks (IWM) to increase diversification. An alternative approach is to focus on buying fewer, higher-quality stocks via S&P 100 Equal Weight ETF (EQWL).

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