It’s Getting Harder to Diversify Your Investments. What to Do About It.

There are few universal truths in investing—buy low and sell high, the relationship between risk and return, and the need for diversification are among them.

Diversification has become such a core tenet of investing that it is largely responsible for the multi-decade boom in index investing, and the reason the world’s largest mutual fund,

Vanguard Total Stock Market Index

(ticker: VTSMX), recently crossed the $1 trillion mark. The two largest exchange-traded funds, which together have $580 billion in assets, track the

S&P 500


But investors in these funds don’t have diversified portfolios. The broad indexes, so often touted as diversified, really aren’t—not anymore. That’s because the market itself isn’t truly diversified. That sets investors up with a conundrum: What does it mean to own a diversified portfolio if the S&P 500 itself is at its most concentrated in decades? And the bigger question: Is diversification still important?

The reason for diversification is simple, and still valid: Most market returns are driven by a small percentage of stocks, but we don’t know which ones will pull ahead, or when. Instead of trying to pick those winners—essentially putting all your eggs in the one basket—diversification reduces risk and volatility by spreading out the bets. When one investment performs poorly, others could offset the losses.

The problem is, there is no universal definition of diversification. If simply judged by the number of components, funds that track the S&P 500 or other broad-market indexes—perhaps owning hundreds, if not thousands, of stocks—are indeed fairly diversified. But indexes that assign weights to components based on size have become exceedingly top-heavy as a small group of stocks have grown exceedingly large.

Read More in Funds Quarterly

Ten years ago, the five largest U.S. stocks made up just over 10% of “the market,” as represented by the S&P 500. In September 2020, the five largest companies—







(FB), and


(GOOGL)—accounted for nearly a quarter of the index, the highest percentage in at least two decades. That concentration had fallen to 21% by the end of the year.

As of September, those five stocks were up an average of nearly 60% for the year, and due to their large sizes, contributed to more than 80% of the S&P 500’s gains. But half of the stocks in the S&P 500 were actually down for the year, and more than a quarter were trading in bearish territory, 20% or more below where they started in 2020. That means the index was disproportionately lifted by just a few names. Investors in S&P 500 funds are making bigger bets on fewer stocks than they likely realize.

That’s fine so long as the stocks are rising, but if they fall—or even just lag behind—S&P 500 and other capitalization-weighted funds will be hit harder. Another risk: Missing out on faster-growing, better-performing stocks. None of the top five were among last year’s 10 best performers. Smaller stocks like


(ALB) and

L Brands

(LB) more than doubled last year, but because of their size, barely moved the index.

There are two broad aspects to diversification: within each fund, and throughout your entire portfolio. Finding a truly diversified fund takes effort, but there are plenty to choose from.

Some funds include more stocks, which helps. But the benefit can be limited, since smaller names make up tiny weights in a capitalization-weighted portfolio. When the top five made up 24% of the S&P 500 in September, the Vanguard Total Stock Market Index fund—which owns more than 3,500 stocks, or seven times as many as the S&P 500—still had 20% of its weight in the group; only slightly less concentrated.

“Percentage of assets in top holdings is a good proxy for concentration risks on an individual stock level,” says Morningstar ETF specialist Alex Bryan. “A lower number means you are spreading your bets across more companies.”

Another option: index funds that use factors other than market capitalization to decide how much of each stock to own, and/or set constraints on the weight of individual stocks or sectors.

A metric called the Herfindahl-Hirschman Index—originally developed to gauge industry competition for antitrust law—can also be used to measure diversification in a fund portfolio. By squaring the market share of each business participant—or, in this case, squaring the weight of each stock—and summing them up, the metric reflects the dominance of large players in a group. By owning the same amount of every stock, regardless of its size, the

Invesco S&P 500 Equal Weight

(RSP) has a Herfindahl score seven times lower than that of the cap-weighted

iShares Core S&P 500

(IVV), even though the two funds own the same stocks.

Sometimes a less-skewed weighting scheme could offset the higher concentration typically brought by fewer stocks. The

Invesco S&P 500 Low Volatility

ETF (SPLV), for example, owns only 100 stocks but weights them by volatility rather than market cap. The fund’s top five holdings make up just 6% of the portfolio, and its Herfindahl score is much lower than the iShares Core S&P 500 fund, which owns five times as many stocks.

But true diversification is also about the relationships among holdings. Typically, stocks in the same industry, or those that are driven by similar macro trends, are more likely to move in tandem. When oil and gas prices fluctuate, for example, all the businesses along the energy supply chain will be affected. A portfolio with hundreds of stocks only in those sectors wouldn’t be considered diversified.

Tobam, a French asset management company, has its computer algorithms analyze massive amounts of market data regarding how every two stocks have moved in relation to each other in the past. It then combs through all the possible stock combinations to identify the portfolio with the maximized diversification score, where holdings are least likely to move in tandem.

Tatjana Puhan, Tobam’s deputy chief investment officer, explained to Barron’s how this can help improve risk control: During the Fukushima nuclear disaster in 2011, the utility company operating the affected power plants,

Tokyo Electric Power

Company, or Tepco, saw its stock take a steep dive. Although Tobam’s Japan portfolio had a large position in the stock at that time, it was able to beat the market thanks to the low correlation among its holdings. “If we hold Tepco, the rest of our portfolio is basically anti-Tepco, and they will behave pretty differently,” says Puhan. That turns out to be better than owning thousands of stocks in an index fund that simply plunged along with Tepco.

It’s probably not the best decision to systematically decide that you shouldn’t be in the top 10 names.

— Chris Tidmore, Vanguard

It’s crucial that investors realize that diversification is a risk strategy—and, like any tactic designed to reduce risk, there is a likelihood it will also limit performance. A diversified stock fund, by definition, will own less of Apple, Amazon, Facebook, and the like, which means it could underperform the S&P 500 when those stocks have big years.

Tobam’s Maximum Diversification USA strategy—recently available to retail investors in the $107 million

Nationwide Maximum Diversification U.S. Core Equity

ETF (MXDU)—has beaten the MSCI USA Index from 2012-14, but lagged behind from 2015-19. The Invesco S&P 500 Equal Weight ETF has shown a similar pattern when compared with its cap-weighted peer.

“If I started saying that the market is top-heavy, moved to indexes that aren’t cap-weighted, and they didn’t do that well, then I haven’t done my job properly, because of these biases that I may have,” says Ron Vinder, an advisor with Morgan Stanley Private Wealth Management.

Chris Tidmore, senior investment strategist at Vanguard, agrees: “It’s probably not the best decision to systematically decide that you shouldn’t be in the top 10 names.”

This is also why so many actively managed funds are so-called closet indexers: Managers are compared to the broad benchmarks, and deviating too much can mean too much risk of underperforming. Active share is a measure of how much a fund looks like its benchmark index. The higher the number (up to 100), the less a fund looks like, and will behave like, the index. Of course, a high active share doesn’t necessarily mean a fund will outperform.

Market leaders can remain in the top spots for a very long time, Tidmore says. “


was in the top 10 for nine decades,

General Electric

for six or seven decades, and [there were similar stretches for]


General Motors.

” But that can be true without the same level of concentration we have today. And when this trend toward greater concentration reverses, diversified funds can cushion the blow—or outperform.

There are already signs of change: Although the recent inclusion of electric car maker


(TSLA), now the fifth-largest stock in the S&P 500, has arguably made the index even more concentrated, the six largest names now make up 23% of the index, less than the top five did just a few months ago. Since the end of October, the S&P 500 Equal Weight index has outperformed its cap-weighted peer by 4.4 percentage points; Tobam’s Maximum Diversification ETF also beat its benchmark by the same amount during the time period.

Portfolio diversification is both easier to achieve and more important. Vinder says that instead of the S&P 500, he builds portfolios using other index funds with a focus on growth or value stocks, small-caps, mid-caps, international markets, fixed income, and commodities. The allocation to each group depends on the clients’ risk tolerance. “By having different weightings to these other indexes and asset classes, I can control diversification a lot more cleanly and smoothly for my clients,” he says.

One common misconception people have, says Vinder, is that by introducing a riskier asset class—such as small-caps—the whole portfolio will become more aggressive, too. The truth is, the more asset classes a portfolio has, the more conservative it gets. When an asset class is eliminated from the portfolio, that’s when it gets riskier. Putting all money in bonds, for example, might seem like a conservative strategy on the surface, but investors could end up with a lot of unwanted risk if interest rates rise and bond prices fall. In that case, adding stocks to the mix helps. “Even though equities by themselves have more risk,” Vinder says, “in a diversified portfolio, it actually brings the risk down.”

Write to Evie Liu at

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