This investment may not be as safe as you think.
S&P 500 (^GSPC 0.08%) exchange-traded funds (ETFs) are incredibly popular investments, and for good reason. The S&P 500 index itself is a powerhouse, containing stocks from 500 leading U.S. companies.
However, this type of investment has a hidden risk, and it may not be as safe and stable as some investors believe. Here’s what you need to know if you own an S&P 500 ETF or are considering investing in one.
Image source: Getty Images.
The tech takeover
Most S&P 500 ETFs are weighted by market cap, meaning the largest companies in the index make up the largest proportion of the portfolio. That’s not necessarily a bad thing, but as tech giants get bigger and bigger, these companies now dominate the S&P 500.
Nearly all of the top 10 stocks in the S&P 500 are from the tech industry, and the top three holdings — Nvidia, Apple, and Microsoft — combined make up roughly 20% of the entire index by market cap weight.
Tech stocks can be incredibly lucrative, and larger companies, in general, do tend to be somewhat more stable than smaller corporations. However, tech also has a reputation for being volatile. Many major tech companies are also heavily involved in the advancement of artificial intelligence (AI), which can be both an advantage and a risk, depending on how that sector fares going forward.
Again, the S&P 500’s heavy tech focus isn’t inherently a bad thing. But many people invest in this type of fund because they’re looking for stability, so it’s a good idea to understand how the index’s changing composition affects its risk profile.
A more stable alternative
S&P 500 ETFs can still be fantastic investments, and their tilt toward tech can make them more lucrative than in the past. But if you’re seeking an S&P 500-focused fund that’s not quite as tech-heavy, an equal-weighted S&P 500 ETF could be a better fit.
Take the Invesco S&P 500 Equal Weight ETF (RSP 0.09%), for example. This fund still tracks the S&P 500, holding all of the stocks within the index. However, each stock makes up roughly 0.2% of the portfolio, regardless of its market cap.
The advantage of an equal-weight ETF is that large companies don’t have a disproportionate sway on the fund’s performance. This can work well in periods of volatility, as this type of fund is less likely to face serious fluctuations. The downside, though, is that it also may have limited earning potential.
RSP Total Return Level data by YCharts
Over the last five years, for example, the S&P 500 has outperformed the Invesco S&P 500 Equal Weight ETF by a fairly significant margin. However, throughout the bear market in 2022, the Invesco ETF experienced milder drawdowns than the S&P 500 — despite tracking the index.
If you’re worried about potential market turbulence, an equal-weight S&P 500 ETF can help limit the volatility tech stocks are famous for. Just keep in mind that less exposure to tech stocks can sometimes lead to lower long-term performance, too.