The Illusion of Diversification: Why Your US Index Tracker May Be Riskier Than You Think

June 2025

By Will Glyn

Are You Really Diversified? Why Index Weighting Matters More Than You Think

Many investors assume that holding a US index tracker provides instant diversification. After all, indices like the S&P 500 contain hundreds of companies. But the reality is that your portfolio might be far more concentrated than it appears — and that comes down to how these indices are structured.

Most indices, including the S&P 500, are market-cap weighted. This means companies are represented based on their total market value. As a result, a small group of large-cap stocks can dominate the performance of the index.

Take the S&P 500 as an example: as of early June 2025, just nine companies made up 36% of the index by weight. Despite the index including around 500 companies, your returns are heavily influenced by just a few names.

These nine giants — Nvidia, Microsoft, Apple, Amazon, Alphabet, Meta, Broadcom, Tesla, and Berkshire Hathaway — each have market capitalisations exceeding $1 trillion. When these companies are performing well, the index can soar. But if they falter, the drop in a market-cap weighted tracker can be more pronounced than many investors expect.

A Different Approach: Equal-Weight Indices

One way to reduce concentration risk is to consider an equal-weight index. These indices include the same companies as their market-cap counterparts, but each stock carries the same weight — around 0.2% in the case of the S&P 500 — and the index is rebalanced quarterly.

That means the top nine stocks mentioned above would collectively account for just 1.8% of the S&P 500 Equal Weight Index, instead of 36%. This structure gives you broader diversification and may naturally tilt your portfolio more toward value opportunities, as underperforming stocks are regularly rebalanced back up in weighting.

However, there are trade-offs. Equal-weight indices tend to have more exposure to mid- and small-cap companies. These companies can be more volatile and less established, which can increase overall investment risk. So, while the diversification is improved, the ride may be bumpier.

What About Performance?

Looking at historical data, the market-cap weighted S&P 500 has outperformed the equal-weight version over the long term. Over the past 20 years, it delivered a total return of 555%, compared with 507% for the equal-weight version. The 10-year gap is even wider: 223% vs. 149%.

This doesn’t necessarily mean one approach is always better. The choice between equal and market-cap weighting often comes down to how comfortable you are with concentration. If you’re uneasy with a handful of tech giants driving the bulk of your returns, equal weighting can provide a more balanced alternative.

From the Magnificent Seven to the Nifty Nine

The dominance of the so-called Magnificent Seven — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla — has been a key theme in recent years. But now, two more names have joined the trillion-dollar club: Broadcom and Berkshire Hathaway. This makes the S&P 500 a little less reliant on the original seven, though the index remains highly top-heavy.

Today’s S&P 500 is much more sensitive to movements in its largest constituents than it was 20 years ago. That means periods of volatility could result in sharper swings — both up and down.

Finding Balance

If you’re unsure whether to go the equal-weight route or stick with the traditional market-cap approach, you don’t necessarily have to choose one over the other. Many investors opt to split their exposure between both, aiming to benefit from the growth potential of the top performers while also spreading risk more evenly.

In a market where concentration risk is becoming harder to ignore, equal weighting offers a valuable alternative — or at the very least, a useful complement — to traditional indexing strategies.

Will is an Independent Financial Adviser with over a decade of experience helping expats make the most of their international status.