Sometimes following the herd works wonders. It certainly has for U.S. large-cap equity investors who have been using passive strategies, and more specifically, mutual funds or ETFs indexed to the S&P 500®, which has become the default proxy for domestic large caps. As investors pile into the Magnificent Seven¹, their market capitalizations have ballooned and their influence over the performance of the S&P 500 continues to grow.

Consider that as of the end of October, the Magnificent Seven represented more than 30% of the S&P 500. That’s seven individual companies that unquestionably are driving the performance of a basket of 500 or so names. As long as these behemoths continue to drift higher, nobody seems to mind. Yet this dominance is unlikely to last forever, and there may come a time when the top few companies underperform the rest of the market. Is it finally time for investors to kick the tires on alternative—and more diversified—indexed equity approaches?

Market cap-weighted benchmarks like the S&P 500®, whereby the constituent makeup is based on company size, may not be the optimal way to invest for the long-term. According to our research, this is the most concentrated that the index has been in over 50 years. And for more context, just one company, Apple, boasts a whopping market cap of more than $3.5 trillion, which is more than the GDP of France, according to IMF data estimates for 2024. All this should give investors pause as it relates to concentration risk. How balanced or diversified is a portfolio that’s built around a cap-weighted index dominated by a few mega-cap companies?

We are here to remind investors that there are other approaches worthy of consideration for a core equity allocation, especially if diversification and risk management are among the top goals.

Below is a table summarizing some of the more popular equity indexed methodologies. Each has its own merits and limitations. For example, many investors seeking an alternative to cap-weighting choose an equal-weighting approach, which allocates equally to all constituents but unfortunately gives no regard to risk. Other approaches are focused on building a lower-volatility portfolio, which for obvious reasons may be appealing to risk-averse investors nearing retirement but still needing some equities exposure. In both cases, investors must be wary of the unwanted portfolio biases that may result.

Source: Victory Capital

One methodology that we believe merits strong consideration is volatility weighting. This builds an equity portfolio by giving larger weights to less volatile stocks and smaller weights to more volatile stocks. Intuitively, equalizing the risk contribution across a portfolio seems like a smarter path to achieving broad diversification and building a portfolio that is both truly diversified and durable over a full market cycle.

Ultimately, you have many choices to consider when it comes to making a passive equity allocation. You don’t have to settle for the cap-weighted methodologies used by the most popular equity indexes, which we believe are not as diversified as many investors believe. 

¹The name given to a group of seven mega-cap stocks: Alphabet (i.e. Google), Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla.