The S&P 500 has become a big AI bet. Here are some simple alternatives.

By Brett Arends

The large-cap index is nowhere near as diversified as you think

AI stocks, like Jensen Huang's chip giant Nvidia, dominate the S&P 500.

If the turmoil in artificial-intelligence and technology stocks gets any worse, millions of Americans - actually, tens of millions of Americans - are suddenly going to discover that their retirement funds are far less diversified than they thought.

They are going to find out that a shockingly large part of their entire portfolio was being gambled on these AI and technology stocks.

And if those stocks truly crash, ordinary people are going to get hit with losses that are far worse than they ever imagined, and find that they are more exposed than they realized.

If history is any guide, there will be howls of outrage, along with terrible, life-changing losses and painful lawsuits against fund companies.

I hate to sound alarmist, but I genuinely believe most people have no idea about this. After Thursday's plunge I was determined to write and let readers know. What you do with the information is up to you.

Here's the situation: Most people's stock-market exposure is based on the most prominent index, the S&P 500 SPX, which invests in the 500 biggest (or most valuable) companies on the stock market. If you have any regular U.S. stock fund, it will pretty much follow the S&P 500's allocation.

And most of the time, that has worked out great.

But to borrow from the famous advertising line, today's S&P 500 is not your father's S&P 500.

Instead, the AI and technology boom has made the index so ridiculously top-heavy that it invests more of your money in the top 10 companies by market value than it invests in the bottom 400 put together.

The 10 biggest stocks in the index account for 40% of the total. That means if you have, say, $10,000 invested in an S&P 500 index fund, you may think your money is being spread across 500 companies, but in reality you have bet $4,000 of that on 10 stocks.

Most of those top 10 stocks are AI or technology stocks like Nvidia (NVDA), Meta (META), Broadcom (AVGO), Alphabet (GOOGL) and Tesla (TSLA).

I am not making an argument against these stocks. I am not saying this is a bubble (well, I think it is, but that's another story) or that these stocks are ludicrously overvalued or that most of the trillions of dollars they are blowing on data centers are going to what the late Peter Bennett used to call "money heaven."

I am merely saying that this index is not really diversified. And I suspect most of the people who have their money in it think that it is.

AI chip giant Nvidia plunged 9% on Thursday. Did you realize that your S&P 500 or U.S. large-cap index fund had more of your money in that one stock - 7.3% of the total - than it did in the smallest 200 stocks in the index put together?

Was that a conscious choice you made when you bought the S&P 500? Was that what you intended?

This phenomenon is relatively new. Check out this excellent research report by Scott Rubner, head of equities at Citadel Securities, a big stock-market brokerage.

"Semiconductor stocks now represent nearly one-fifth of the S&P 500, the highest share on record," Rubner writes. "Their representation in the index has quadrupled since June 2020."

(And semiconductors, or computer chips, are only part of the broader IT and AI sector.)

A decade ago, if you invested in the S&P 500 you were in fact buying a diversified portfolio. The top 10 stocks accounted for just 17%. That ratio has more than doubled in the 10 years since. It is far higher than it was even during the giddy, insane days at the peak of the great dot-com bubble a quarter-century ago.

If you know you are gambling a gigantic share of your stock-market money on one volatile and risky industry, and that's what you want, then this warning doesn't apply to you.

And if the S&P 500 and U.S. large caps are only a smallish part of your overall stock-market portfolio, it doesn't apply to you either.

But I suspect large numbers of people are pinning the lion's share of their hopes on the S&P 500 simply because that's what history and Wall Street conventional wisdom recommends. If you invest in a company 401(k), it probably offers a limited range of funds, and you're advised to put most of your money in a low-cost U.S. large-cap fund, which means, more or less, the S&P 500.

Even if you avoid a large-cap fund and put your money in a "total" U.S. stock-market fund, one that supposedly includes all of the stocks on the market, that doesn't help you much. The large caps dwarf everything. For example, Vanguard's Total U.S. Stock Market ETF VTI says it spreads your money across 3,500 U.S. stocks. Sounds great, right?

Some 36% of your money goes into the same top 10.

This is not a criticism of the index funds, which are doing what they are designed to do. It is to point out that a series of developments have produced an outcome that many or most people never intended, and of which they are not aware.

Someone asked me what the alternatives are. I've written here before about equal-weighted S&P 500 or U.S. stock funds, such as the Invesco S&P 500 Equal Weight ETF RSP or the iShares MSCI USA Equal Weighted ETF EUSA, which genuinely spread your money equally across stocks. Those are, by definition, much more diversified.

Another more diversified, low-cost alternative to the S&P 500 large-company index is the S&P 400 MID midcap index. It invests in much the same things - established, profitable U.S. companies traded on the U.S. stock exchange and subject to all the same rules and regulations. And these are substantial companies: The valuation range is between $8 billion and about $22 billion. (For illustration purposes only, names in the fund include Alcoa (AA), American Airlines (AAL), Hyatt Hotels (H), Crocs (CROX), Harley-Davidson (HOG), Toll Brothers (TOL) and Texas Roadhouse (TXRH).)

As it happens, the stocks in the S&P 400 are, overall, cheaper in relation to earnings than the S&P 500, trading overall at 14 times forecast earnings instead of 18 times. But that's not the key point.

The S&P 400 does not leave you beholden to a small number of stocks or a single industry. The 10 biggest companies in the index account for 6.7% of the index by weight - $670 out of the hypothetical $10,000 mentioned above.

(One caveat is that midsize and smaller company stocks are usually more volatile than large caps in the short term, if you care about the short term.)

The late, great Hollywood screen writer William Goldman once famously said of his industry, "Nobody knows anything. ... Not one person in the entire motion picture field knows for a certainty what's going to work."

Much the same is true about Wall Street. That's why very few fund managers have produced sustained outperformance. (Mathematically, most of them must fail.)

We cannot know for certain that the AI boom is going to crash. We cannot know for certain whether midsize companies are going to prove a better bet over, say, the next five to 10 years than large ones. But we can say with absolute certainty that the S&P 400 is much more diversified across individual stocks than the S&P 500 right now. By an order of magnitude. It is far less lopsided and less beholden to any particular company or industry.

And we can reasonably assume that many of those people who hold the bulk of their 401(k) in the S&P 500 do not realize how much of a bet they are actually taking on a few stocks and one industry.

If you're going to make a bet, I figure you should at least know the bet you're taking.

-Brett Arends

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

11-06-26 0952ET