Latest / Look Forward / Partner Perspectives: Decoding Concentration Risk, Index Design, and the Next Era of Choice

Transcript

Partner Perspectives: Decoding Concentration Risk, Index Design, and the Next Era of Choice · Look Forward

0:05
Welcome to Partner Perspectives, a thought leadership initiative from S&P Global
0:10
that brings leading institutions together to examine the trends that shape global
0:15
markets, and we deliver forward-looking analysis that helps market participants
0:20
navigate uncertainty, identify opportunities, and anticipate what's next.
0:26
This miniseries within the Look Forward podcast spotlights our
0:30
first volume, produced jointly with Vanguard, entitled Partner
0:35
Perspectives: The Future of Capital Markets, Unlocking Potential Ahead.
0:41
Across three episodes, we explore the key themes at the heart of this
0:45
research, including shifts in global market structure, index diversification,
0:52
fixed income resilience, and the evolution of private markets.
0:57
Leaders from S&P Global and Vanguard discuss what these changes could
1:01
mean for investors, institutions, and the broader market ecosystem.
1:08
Because progress is rarely the work of one institution or one perspective,
1:12
this research is built on the idea that adaptation and cooperation across
1:18
sectors and borders are essential to unlocking opportunity ahead.
1:24
In this episode, we are narrowing in on one of the most foundational yet
1:29
rapidly evolving themes explored in this joint research, and that is indexing.
1:36
It is a part of the market that can appear simple at first glance, but
1:40
beneath the surface sits decades of innovation, shifting market leadership,
1:45
and increasingly complex investor needs.
1:49
Indexing has become one of the primary ways institutions and individuals access
1:54
the market, and understanding how it is changing helps us understand how the
2:00
entire investment landscape is changing.
2:03
To unpack this story, I'll be joined by two indexing experts.
2:08
First, Tim Edwards, Global Head of Index Investment Strategy
2:13
at S&P Dow Jones Indices.
2:16
His research explores what happens when a handful of companies become
2:20
disproportionately large and what history teaches us about market
2:24
concentration and change at the top.
2:28
Then we'll turn to Jim Rowley, Global Head of Investment
2:32
Implementation Research at Vanguard, to explore how indexing has evolved over
2:37
the last fifty years, what's driving its next chapter, and how investors can
2:42
navigate a market full of increasingly differentiated index strategies.
2:48
Let's start by setting the stage with Tim.
2:51
Tim, welcome to the show.
2:53
Hi.
2:54
Thanks for having me.
2:55
Let's start with the headline finding.
2:57
In your paper, you note that by mid 2025, the ten largest companies in the
3:02
S&P five hundred made up almost forty percent of the index's total market
3:07
cap, a level of concentration that we have not seen since the mid 1960s.
3:13
What made you want to dig into this moment?
3:16
Well, there were two reas-reasons to, to dig into it.
3:19
The first, um, was the outperformance or the, the, the relative increase in heft,
3:26
uh, among the largest companies in the US has been a really driving phenomena
3:32
in equity markets globally and US equity markets especially over the last decade.
3:38
Uh, it's had all sorts of consequences, um, but it's also raised questions,
3:43
questions as to whether or not such a level of concentration represents
3:48
potentially a systemic risk or even a reason, uh, to, uh, uh, move beyond
3:53
capitalization-weighted benchmarks, uh, that measure the markets by literally, um,
3:59
grouping companies and measuring companies according to their, to their size.
4:04
So first reason to look at it was because it's something that really
4:08
matters to the-- to markets right now.
4:10
The second reason is because we do have the advantage of, um, many
4:15
decades of history in the S&P 500 live performance, we had the ability to go,
4:20
if you like, back in time and answer the question, what happened last time?
4:25
Now, of course, the past, uh, as it always says in the, in the disclaimer,
4:28
the past does not guarantee the future.
4:30
Uh, but looking at evolutions and ebbs and flows in concentration in
4:35
US equity markets and what happened the last time we saw a similar,
4:39
similar level of concentration was something that really motivated
4:43
digging into the research that we did.
4:45
So when you spoke about rising concentration, you also linked that
4:49
to huge investor enthusiasm for AI and other disruptive technologies.
4:55
So how important is that technology story to understanding today's giants?
5:01
It's, it's not everything, but it is pretty important.
5:03
Um, so the, the, the, the top 10, um, uh, which, which, you know, we examined
5:08
as of today, uh, include companies which are real, um- Uh, poster child
5:14
for, for, for the tech sector, for the communications sector, uh, and
5:19
for the increasing enthusiasm and optimism around either AI directly or
5:24
the pr-productivity benefits that AI may bring, uh, to the broader economy.
5:28
Um, and, and just if I list the names, you, you'll get a sense.
5:31
So, you know, we have NVIDIA, uh, we have Apple, we have Broadcom, we have Meta,
5:35
we have Alphabet, uh, we have Microsoft.
5:38
Um, but it's not just those companies.
5:41
Also represented, uh, are, uh, you know, the finance industry, JPMorgan,
5:45
uh, and Berkshire Hathaway, uh, and, uh, another, another favorite of,
5:49
um, of the traders, Tesla, uh, which of course has connections to but is,
5:54
but is not directly an AI company.
5:56
I think that, that is, um, in itself just, you know, those list of names,
6:01
you can see the importance that the market that investors have placed
6:06
on those businesses, um, in terms of, of the drivers or potential
6:12
drivers of, of profits and growth, uh, in the US, um, economy generally.
6:17
And then, uh, actually there is another interesting element, uh, of, of the
6:20
research is looking back at the top 10 S&P 500 companies back in June 1965.
6:27
So can you walk us through what happened to that group over
6:30
the few decades since then?
6:33
Yeah, absolutely.
6:33
So this was, this was the opportunity that we had, right?
6:36
So, um, you have those, those 10 companies that I mentioned representing
6:40
about forty percent, almost forty percent, uh, of the S&P 500.
6:44
Um, so and we've looked back in time, and we found that in 1965, there
6:49
was, you know, a very different ten companies that represented the same
6:54
proportion of the index, just a little under, uh, uh, forty, forty percent.
6:58
And they're very different, and they contain some names that will probably
7:01
be familiar, uh, to the listeners, but, um, but sometimes for rather notorious
7:07
reasons, uh, than, than success.
7:09
So we have companies that went famously bankrupt, Kodak, um, Sears
7:14
catalog company or Sears Roebuck, uh, & Co., uh, General Electric.
7:18
Um, you have a, a company which is in the tech sector but somehow
7:22
didn't manage to capture as much of the latest wave, uh, in, uh, in IBM.
7:27
And some of, you know, parts of what people see a little bit as, uh, part
7:31
of the old economy, you know, energy majors like, um, like Standard Oil,
7:34
which became, uh, Exxon, and, uh, Gulf Oil, which then later became Chevron.
7:39
Uh, and so what we wanted to do was, was to illustrate how that changing
7:44
of the guard, if you like, over the last sixty years, from 1965 to 2025,
7:49
how that happened and what impact that had on overall market performance, and
7:54
what that can tell us about the way that markets and benchmarks evolve.
7:58
And you also estimate that about ten stocks w-were responsible for roughly
8:03
one-third of the S&P 500 total growth after that initial 1965 snapshot.
8:09
What does that concentration of contribution tell us about
8:12
how equity markets work?
8:14
It tells us something really important.
8:16
Um, it, it shows us, uh, something that intuitively we all know.
8:21
By the way, where does that thirty percent come from, right?
8:23
So you have these, these ten companies which are the current leaders today.
8:28
Well, they weren't always as big as they were, but they were, in many
8:32
cases, long time members of the index.
8:34
Um, in the, uh, in the research, we point out the average tenure,
8:38
uh, among these companies is around a quarter of a century.
8:41
You know, Microsoft joined many decades ago, and it joined at a small weight.
8:46
And if these companies have come from whatever weight they came in, which
8:50
typically are, you know, around point two, point four percent of the index, and
8:55
they're today representing four, five, six, seven percent, that means that if you
9:00
look at the total growth in wealth, the capitalization of the US equity markets,
9:04
if they're a third of it, then they have generated more or less, approximately.
9:08
They've generated a third of the overall increase in capitalization
9:12
over the time, at least.
9:14
Um, and this is, this is a dynamic that is fundamental to,
9:18
to the stock markets, right?
9:19
There, there are over ten thousand companies which have ever been
9:23
available to trade on the New Stock Exchange, um, and just few of them
9:28
survive, and a very small few of them, uh, come to represent a significant
9:33
proportion of the overall market.
9:35
They've done it before.
9:36
Uh, they will very well likely do it again, and it shows you that the returns
9:40
in the stock market, yes, um, you know, th-they-- many stocks can do well,
9:46
but the overall market is often pulled higher or drifts higher, thanks to the
9:50
contributions of a few select superheroes, um, who really outperform all their peers.
9:57
Let's fast-forward to today's cohort.
10:00
Yeah.
10:00
You tracked the current top ten companies as of June 2025, tracing back through the
10:05
corporate predecessors where necessary.
10:08
What did you learn about how these firms rose to the top?
10:13
Yeah, it's really interesting.
10:14
I me- I mentioned the phrase changing of the guard, and I think that's,
10:17
that's really an important concept.
10:20
Um, so you have-- You go back nineteen sixty-five to today, you have a
10:23
concentration of, um, you know, top ten taking up forty percent at the
10:27
start and at the end of the period, and in between there are ebbs and flows.
10:31
And concentration can change, if you like, in, in two ways, right?
10:35
Concentration can change because the biggest companies underperform, and so
10:38
they come to represent smaller weights.
10:40
Or, um, you know, equivalently, but from a slightly different perspective,
10:44
it could be that other companies are coming to take their place.
10:48
Other members of the index are, you know, gaining momentum,
10:51
picking up steam, and coming to represent a larger and larger share.
10:55
And over the full history, uh, of, uh, of the US equity markets, it's
10:59
really this changing of the guard that drives ebbs and flows in concentration.
11:04
The current t-top ten cohort, uh, I don't wanna say they came from nowhere,
11:08
it took them a long time to get there, um, but they essentially grew from
11:12
very small weights to large weights just as the old cohort were falling
11:17
from large weights to, to small.
11:19
So it's this, it's this dynamic of reinvention, uh, which characterizes
11:24
equity markets and w- and which is really visible, uh, on those, on
11:28
those, uh, in the comparison between, you know, where we were sixty years
11:32
ago and, and where we are today.
11:34
Actually, many listeners will still worry, you know, if the current giants stumble.
11:40
Does that put the whole market at risk?
11:43
Um, well, uh, so here's what's, here's what's interesting.
11:46
Not necessarily.
11:47
Uh, partly because of the dynamics I've just mentioned.
11:50
Um, partly because really it's, it's about relative, uh, performance, not absolute.
11:56
And one of the things that you can do is, is you can, you know, measure
11:59
concentration, like what was the weight of the top ten at the time or another…
12:02
any other measure of concentration.
12:04
You can look at that, how it evolves over years, decade, months, years.
12:07
And what you find is that statistically there is an association between
12:12
the underperformance of the larger stocks and the performance
12:14
of the, of the overall market.
12:17
But it's a very weak relationship.
12:20
Um, in fact, you know, something you can, you can sort of get
12:23
straight away is, is from nineteen sixty-five through to twenty thirteen,
12:26
concentration declined enormously.
12:29
Uh, and they were a fantastic, fantastic fifty years or so for,
12:33
for, for the US stock market.
12:34
So it's-- You don't necessarily need to believe that the current giants need
12:40
to continue to outperform in order for the broad US equity market to do well.
12:45
However, if they do falter, a diversified broad approach can help you do something
12:52
really important, which is to ensure participation in the next generation
12:58
of, if you like, you know, minnows that are, that are hoping to become big fish.
13:02
And that's, that's actually why we called the, the, the paper In the Shadows of
13:05
Giants, to give the, the sense that potentially or perhaps already out there
13:09
and growing today, um, there are members of, of the next top ten cohort whenever…
13:14
whoever or wherever they may be and come.
13:18
So let's bring all these down to the investor level.
13:21
A, uh, common reaction to high concentration is to say, "Well, I should
13:26
move away from market cap weighted index funds." But in your conclusion,
13:29
you were actually fairly positive about sticking with broad cap weight
13:34
benchmarks like the S&P five hundred.
13:37
Why is that?
13:39
Um, partly because their, their, their long-term history shows that
13:42
by allowing companies to fail, um, they allow others to rise.
13:48
Um, you know, the important thing about capitalization weighting is
13:52
it's not making a judgment, it's just representing the whole market.
13:56
If big companies start to do worse, then the weights in capitalization weighted
14:01
benchmarks will decrease accordingly.
14:04
Uh, and by the time if, if this does happen, by the time you have a really
14:07
big company that gets very small, its weight has now got very small.
14:10
And conversely, if you have, you know, new innovative companies that are coming to…
14:16
that are outperforming, that are coming to represent a more significant part
14:20
of the economy, capitalization weighted benchmarks don't make their own judgment.
14:24
They follow the market's judgment, and the size of the position will grow, not
14:29
because index funds are buying more of them, but simply because their performance
14:33
is Giving them a higher weight, right?
14:36
So it's just tracking the market that rather than,
14:39
rather than trying to beat it.
14:41
So I think it's, it's, it's those two pieces, you know.
14:43
Looking at long-term history shows how broad capitalization weighted
14:47
benchmarks can evolve and do evolve with markets, and also just remembering
14:52
that key concept that by taking broad cap-weighted exposure, you're not making
14:57
a judgment on which company is more or expensive or too cheap, you're just
15:02
participating in the overall growth or falls, uh, in the total market.
15:09
That was a fascinating look at how markets behave when giants dominate
15:13
the landscape and how much investors can learn from looking back at both
15:17
history and today's concentration.
15:20
Now we're going to take that foundation and widen the lens.
15:24
If Tim helped us understand how the market itself evolves, our next guest
15:29
helps us understand how investors choose to navigate that evolution.
15:34
Joining me now is Jim Rowley, Global Head of Investment Implementation
15:38
Research at Vanguard, to walk us through how index investing has transformed
15:43
over the last fifty years and what that means for investors today.
15:48
Jim, welcome to the show.
15:50
Thank you very much, Aries, for having me.
15:52
I appreciate it.
15:52
I'm looking forward to the conversation.
15:55
Awesome.
15:55
So let's start with the big picture.
15:57
Fifty years ago, Vanguard launched the first index mutual fund, giving investors
16:02
simple access to the S&P five hundred.
16:05
A single fund, one benchmark, and broad market exposure.
16:09
How would you describe the original value proposition of that first fund,
16:13
and what made it so revolutionary?
16:17
I think ironically, and, and this might be circular logic, but the very notion of
16:22
the index fund itself was revolutionary.
16:24
And you, you just described it, this idea of a, a, a single
16:28
benchmark, broad market access.
16:31
You know, back in the-- at that time, investing was largely an endeavor of
16:35
active management, which means that investors had to bear the risk of
16:39
a-attempting to outperform the market.
16:42
But, you know, we've seen the results in the data, and in many cases,
16:45
underperforming the market, and they were probably carrying reasonably
16:49
high cost structures to do so.
16:51
And, and this idea that investors would s- would invest in a fund that
16:56
would just give them the market's return, providing them simple one-fund
17:01
implementation at a very cost-effective way of doing it, that in and of, in
17:07
and of itself was a revolutionary idea.
17:09
And fast-forward to today.
17:11
What has changed since then?
17:14
Well, I think markets have matured a bit.
17:16
I think, uh, investor preferences have shifted and, and I think if we,
17:20
we look at that S&P 500 index fund as, as a cornerstone, we've now seen
17:26
this rapid development of different types of index fund strategies.
17:30
We've seen strategies that focus on, uh, you know, specific sector exposures.
17:36
We see index funds that focus or give access to different size and, you
17:40
know, market cap size and styles, uh, regions, country-specific,
17:45
uh, those types of exposures.
17:47
But ironically, we've also seen the development of, of total market exposures.
17:51
The idea that for some investors, you know, they would like really
17:55
a one fund of the total market.
17:57
And, and what I mean by that is, whereas the S&P 500 provides great
18:02
representation to a broad swath of the U.S. equities market, um, it's
18:07
not, it's not the total market itself.
18:09
And now with this development of targeted funds and total market funds, investors
18:14
have a great set of tools that give them flexibility and, and additional means to
18:19
add customization to their portfolios.
18:22
So as index strategies evolved to offer a wider range of exposures
18:27
over time, Jim, how do you think this expansion changed how investors
18:31
use index funds in portfolios?
18:35
Well, the phrase that we like to use is it's investors are
18:39
able to use passive for active.
18:42
And a, a great way that I think we can illustrate this is, you know,
18:46
many investors are, are familiar with the concept of core satellite.
18:50
It was a way of saying, "I'd like to engage in some type of active-passive
18:54
combination with my funds, and maybe I will do that by holding a core, uh, an
18:59
S&P 500 index fund, and then I'll use active satellites to get further exposure
19:05
and, and attempt to beat the market." And that might mean in a-- if I use a simple
19:09
example, that might mean adding an active mid-cap fund and an active small-cap fund.
19:15
Well, now what we've seen with this development of index funds is using
19:19
passive for active means instead of the old core satellite thought, it's now I
19:26
will have the S&P 500 index fund, but now I'll also own the S&P mid-cap index
19:31
fund and an S&P small-cap index fund.
19:34
And the trade-off for investors is, you know, with the, with the prior portfolio,
19:39
you had a chance of sort of adding manager selection outperformance in mid and
19:44
small-cap markets, but you ran the risk of maybe gaps and overlaps because you
19:48
might not have full transparency to what each of those active managers was doing.
19:52
But now with this idea of just holding three index funds, you know, the
19:57
investor who's building that portfolio has a little bit more precise control
20:01
of setting the allocations to large, mid, and small, and eliminating the
20:05
additional layer or that uncertainty that comes with using active managers.
20:10
So one of the key takeaways also from your team's research is that
20:14
index labels can be misleading.
20:16
So can you help us unpack why understanding an index
20:19
methodology actually matters?
20:23
An index's job is to, uh, reflect an, uh, an investable opportunity set.
20:28
Um, but when an index provider has to make that a reality, they actually
20:32
have to build it and, and construct it.
20:35
And normally that begins with what are the securities to be included
20:39
in that index and in what weights, you know, proportions, et cetera.
20:44
Now, typically, if an index provider starts with a market such as the, the
20:48
U.S. equity market, there's probably not going to be too much differentiation,
20:53
uh, when you're thinking about just the total U.S. equity market.
20:57
But once index providers start to carve up the market into smaller segments,
21:02
they have to make decisions such as where's my cutoff to determine size?
21:08
Like what's large, what's mid, what's small?
21:11
They have to determine style, like what's a growth or what's a value stock?
21:15
And they also have to determine their rebalancing frequencies.
21:19
And they don't all agree on those methods, and what you end up with
21:22
is situations with index providers where their versions of large, mid,
21:27
and small, you know, they might have a different number of securities.
21:31
They might have relative drift in terms of maybe one person's mid-cap
21:35
index is a little bit larger than the other person's mid-cap index.
21:40
And that's why understanding the methodology and how those constituents
21:45
and portfolios are arrived at is far more important than simply what's the label.
21:51
Can you give us one concrete example of how index methodology
21:55
can alter outcomes even when the index name sometimes sounds alike?
22:00
Yeah.
22:00
You know, I was, I was thinking about this the other day and, and, uh, if somebody
22:05
had said to you, Aries, "Hey, how did small caps do? How did U.S. small caps
22:09
do in 2024?" And I'll, I'll use 2024 because the, the research referenced, uh,
22:14
we, we take a look at the end of 2024.
22:17
I would say, well, it depends upon whose definition you are looking at.
22:21
And I, I won't name the names, but if we look at the three major index
22:24
providers and their, their respective small cap indexes for 2024, you,
22:30
you could have gotten a return of something around 8%, another one
22:34
around 11%, and another one around 14%.
22:38
And that's a very simple label, oh, how did small caps do?
22:41
But each one of those returns is a function of their
22:44
respective methodologies.
22:47
So let's look ahead, Jim.
22:48
Vanguard's research points to greater differentiation as the next phase.
22:53
So what kinds of innovations are we talking about?
22:57
I think we'll probably see the sort of development of very targeted and specific
23:03
strategies in index fund development.
23:05
But I think maybe the one form of differentiation that most are
23:09
looking towards i-in the future revolves around direct indexing.
23:13
And I think that is a very important focus because it, it brings the,
23:19
the hope, uh, of customization.
23:22
And I, I can think of three ways that customization would
23:25
be utilized by investors.
23:27
One of which is tax loss harvesting.
23:29
The second one might be for what we would call ESG preferences.
23:33
And I know the, the popularity of ESG investing, you know, is a little
23:36
bit higher, it's a little bit lower.
23:39
But with direct indexing, customization is done at the individual investor level, and
23:44
you really don't need to have a debate.
23:45
If, if you and I just have different personal preferences
23:48
around sectors we want or sectors we don't want, that's great.
23:53
The customization of direct indexing lets each of us make
23:56
those choices, and they don't, they don't really affect one another.
24:00
And the third area of customization is maybe a little
24:03
more specific active decisions.
24:06
You know, maybe there are investors who like the customization to say, "Oh, I,
24:10
I prefer to put on some type of factor tilt," or maybe, "I think I have the
24:14
ability to add some edge on security selection based upon my own homework."
24:19
And I think looking ahead, what direct indexing really offers, it's,
24:23
it's not just the differentiation, but it's, it's the differentiation
24:26
that comes through customization.
24:29
And where does this evolution leave the traditional index funds?
24:32
Are they still relevant in this new, uh, landscape?
24:36
I still th- To me, they're still front and center.
24:38
Uh, I-- What I've talked about before is investors, especially when you are
24:43
looking at major index providers and they offer a, a holistic family tree,
24:48
if you will, of their indexes where you, you start with the total market funds.
24:54
B- And their lineups usually then give you the ability to sort of break
24:57
down the total market and rebuild it in a way that best meets your needs.
25:02
I think they're front and center and incredibly key tools going forward.
25:06
And here is my last question for you.
25:08
So for listeners managing their own portfolios or advising
25:12
clients, what are the key takeaways, uh, from this evolution?
25:17
Well, I think for me there's really two keys, one of which we
25:20
talked about before is, you know, don't pay attention to the labels.
25:24
It's really important to understand index provider methodology and what does that
25:29
mean for your fund's characteristics.
25:32
So putting labels aside, focus on the characteristics.
25:36
I think the second part is realizing index funds are not a panacea.
25:40
They are tools, and they are very important tools that should be
25:44
used in the context of a portfolio.
25:47
We should be looking at index funds as great tools to help investors build
25:51
diversified, low-cost portfolios that align with their objectives and their
25:57
risk tolerances, all in an effort to help them achieve investment success.
26:02
Thanks, Jim, and that brings us to the end of today's episode.
26:06
From Tim's look at market concentration and the long arc of performance
26:10
leadership to Jim's deep dive into how indexing has broadened and evolved,
26:15
one theme came through clearly.
26:17
Markets change, leadership changes, and the way investors navigate those
26:22
changes continues to evolve as well.
26:24
That is what making this partnership between S&P Global and Vanguard so
26:29
important, bringing together complementary expertise to offer clarity in a complex
26:34
world with insights designed not only to inform but to help market participants
26:39
channel knowledge into action.
26:42
To learn more, read the full collection of research on spglobal.com.
26:47
Thank you for listening