1Q26_ Quarterly Outlook Report_Final_EN - Flipbook - Page 22
T H E P LUMB LI N E | A RETU RN TO F I RS T PRI N CI PL ES
Another way to illustrate concentration risk is by calculating the effective number of constituents
which translates the index’s weight distribution into an intuitive measure of its underlying
diversification. Given that the S&P 500 has ~500 stocks – as indicated by its name – one may
assume a certain level of diversification comes from holding such a broad array of companies.
This would be true if the index were equal-weighted, but cap-weighted indices like the S&P 500
by their nature could have a small subset of stocks exerting an outsized influence on broader
performance.
Rather than asking how many stocks there are in the S&P 500, the effective number of
constituents measure seeks to find the number of stocks that meaningfully account for the
index’s risk characteristics. Currently, the effective number of constituents in the S&P 500 is
around 47, suggesting that the index behaves more like a portfolio of ~50-equal-weighted stocks
rather than 500 as its name would suggest. Lower effective breadth means index performance
and risk become increasingly driven by a handful of names, making the index more vulnerable to
idiosyncratic shocks, leadership reversals, or regulatory and earnings risks concentrated in those
companies.
Narrowing market leadership has increased the S&P 500’s concentration risks in recent years
180
150
120
90
60
30
0
1988
47
1992
1996
2000
2004
2008
2012
2016
2020
2024
Effective # of S&P 500 constituents
Source: Bloomberg Finance LP, Scotia Wealth Management
Elevated valuations combined with high index concentration have raised concerns about future
return outcomes. The chart below shows the historical relationship between forward P/Es and
10-year forward returns, implying roughly flat forward returns over the next decade.
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