The S&P500 it has long been sold as an effortless way for British investors to invest in top US stocks. The idea is straightforward: choose a decent fund that tracks the S&P 500 and you’ll essentially be investing in the 500 largest US companies – instant diversification.

But this may no longer be a reality. Currently, a tiny number of gigantic corporations are responsible for almost all of the index’s gains. So “broad diversification” is actually highly concentrated in one sector: technology.

This is not just a technical detail. It affects risk, volatility and ultimately the long-term potential of the entire portfolio.

So how concentrated has the S&P 500 become?

The S&P 500 index is market capitalization weighted, which means larger companies have more influence. When a handful of large-cap tech companies gain in value, the entire index wins – even if the rest of the market remains unchanged.

Recently, the number of top 10 companies has increased rapidly, gaining an increasing share of the total market value of the index. This means that your investment in the “500 companies” is really focused on just a few tech giants.

For example Vanguard S&P 500 ETF owns 8.4 percent Nvidia7% in Apple4.9% in Microsoft4.1% in Amazon and 3.6% w Alphabet. A further 11.3% was concentrated in five further farms.

This represents 39.3% of the total portfolio. Beginning investors should not overlook this development. The index may look robust, but its performance depends on the success of what may be a frail foundation.

What does this mean for passive investors?

As said, most funds that track the S&P 500 are market capitalization weighted and therefore are more exposed to concentration risk. To limit this exposure, you may want to consider an equal weighted fund such as iShares S&P 500 Equal-weight ETF (LSE: ISPE).

This fund offers UK investors a way to reduce the extreme risk of mega-cap concentration in the S&P 500 Index by assigning equal 0.2% weightings to all 500+ stocks.

The top 10 companies represent just ~2.65% of the fund compared to ~36% in the standard S&P 500 tracking set, providing better diversification and reducing the risk associated with a single action.

The fund also offers a higher dividend give of 1.89% compared to 1.30%, which is attractive to income investors. The naturally even spread means the fund often underperforms other companies tracking the S&P 500 when there is a surge in US technology.

It’s also worth noting that the GBP-secured version’s ongoing cost of 0.17% is slightly higher than unsecured alternatives. Meanwhile, it has a relatively tiny track record, and currency hedging increases costs that can reduce returns over time.

So the trade-off is straightforward: There is less risk if the bloated U.S. tech sector plummets, but it is more vulnerable to losses in other sectors.

Final thoughts

The S&P 500 index is no longer just a straightforward, balanced investment in American business. Instead of 500 individual companies, it’s more like a handful of carefully balanced companies wearing an S&P 500-branded trench coat.

If you understand these risks and still believe in the long-term direction of the U.S. economy, the index can still be a astute core holding.

However, if you want true diversification, you may want to look at equally weighted funds, sector-balanced portfolios, or global indexes alongside the S&P 500.

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Mark Hartley holds no position in the companies mentioned.