Do Index Funds Really Offer Diversification? Not as Much as You Think
Written by
G. Brian Davis
Edited by
Jenna Klaverweiden
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When you buy shares in an index fund — which is a selection of assets that track a certain index — you get the diversification of all those different stocks, right? Kind of.
With the rise in popularity of passive stock investing, more people than ever before are simply buying shares in exchange-traded funds (ETFs) and assuming their stock portfolios are diversified. Some use robo-advisors to buy these ETF shares for them and have little understanding of the underlying investments.
But the convenience could come at the cost of the index funds becoming dangerously top-heavy. Here are more details on why index funds may not offer as much diversification as you think.
Weighting in the S&P 500
Yes, the S&P 500 includes 500 companies. But the largest of those companies make up a disproportionate percentage of the index’s weighting, as it’s a market-capitalization-weighted index.
The largest company alone (Apple) makes up roughly 7% of the index’s weighting, as demonstrated by the Slick Charts breakdown of all 500 stocks’ weightings.
Earlier this year, the top 10 companies added up to roughly the same percentage (37.6%) as the bottom 450 companies (38.3%). The tech giants at the top have suffered some over the past few weeks, so as of early February, the top 10 represent “just” 36% of the index.
Again, 2% of the index makes up over 36% of the weighting. Does that sound diversified to you?
So if you bought a market-capitalization-weighted index fund that tracks the S&P, you’d be exposed to that same weighting.
500 Companies — or 59?
In 2024, when equity fund giant GMO ran the numbers on just how top-heavy the S&P 500 had grown, it found that the index represented the equivalent of an equal-weighted fund with just 59 stocks.
GMO went on to note that the index was more than twice as diversified a decade prior. At no other 10-year period have we seen that great a change in diversification, GMO reported.
How To Diversify Your Portfolio Without Buying Individual Stocks
So considering that market-capitalization-weighted S&P 500 index funds don’t offer the type of diversification many think they do, what should you do?
Sure, you could go out and buy individual shares of the 500 companies in the S&P 500 (or any other stock index). But that sounds like a huge pain in the neck.
How else can you diversify your portfolio? There are some other types of funds to consider. (Note that some mentioned I own in my personal portfolio.)
Equal-Weighted Funds
In addition to buying shares in standard-weighted index funds like the SPDR S&P 500 ETF (SPY), you can also buy shares in equal-weighted index funds.
For example, the Invesco S&P 500 Equal Weight ETF (RSP) keeps each of the 500 companies’ weightings at a proportionate 0.2% of the fund. That keeps your holdings truly diversified across all 500 companies.
Keep in mind, many index funds own the same few giant corporations — all with heavy weightings. If you own index funds that mirror both the S&P 500 and the Nasdaq 100, you might think you’re diversifying by buying into two different stock indexes. But both of them include Apple, for example, at the very top of the weighting list. And Microsoft, and Amazon, and so forth.
So equal-weighted funds could be a good addition to your portfolio to increase diversification.
Small Cap and Midcap Funds
You can go further down the capitalization ladder by buying small-cap and midcap stock funds as well.
For example, there’s the Schwab U.S. Small-Cap ETF (SCHA) and Schwab U.S. Mid-Cap ETF (SCHM). They do carry standard weightings, but the companies don’t have the same steep weighting curve that the megacap stocks at the top of the S&P 500 do.
International Funds
No one says you have to stick with U.S. companies either.
Diversify your portfolio further by buying shares in international developed market funds and emerging market funds. Some options could be the Schwab International Equity ETF (SCHF) and the Schwab Emerging Markets Equity ETF (SCHE).
Alternatively, you could just buy into the singular Vanguard FTSE All-World ex-US ETF (VEU). It includes stocks from the entire rest of the world, excluding the U.S.
Passive Real Estate Investments
You don’t have to buy a rental property to add real estate to your portfolio.
If you want to stick with the comfort of your brokerage account, you can buy shares in real estate investment trusts (REITs). They come in all shapes and sizes. You can buy U.S.-only REITs or REITs from specific regions around the world. You can buy industrial real estate REITs, multifamily REITs, self-storage REITs or any other asset type under the sun.
You also have the option of private equity real estate investments, but there are a lot of factors you’ll want to consider before going this route, including risk tolerance, minimum investments and liquidity.
A few mega-corporations tend to make up a disproportionate percentage of today’s passive stock funds. It falls to you as an investor to counterweight them — or suffer the consequences when one or all of them topple.
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