Worried about index concentration? Don’t be

The United States is mired in an overseas conflict, inflation is on the rise, Canadians are uniting behind their flag and the top 10 companies in the S&P 500 make up nearly 40 per cent of the index. It is 1965.

Today’s U.S. financial markets, dominated by technology companies and riding on enthusiasm for artificial intelligence, might appear unrecognizable to investors of the 1960s. But modern investors could be exposed to risks that would have seemed familiar a couple of generations ago: With high levels of index concentration – the domination of major market indexes by a small number of names – investors may be far less diversified than they think.

Recent research by Toronto-basedPicton Investments found that 83 per cent of Canadian investors are confident their portfolios are diversified, but only 57 per cent say they are familiar with the concept of index concentration.

Pawan Vatvani, head of portfolio construction, portfolio strategist at 2nd Engine by Picton, said both retail and institutional investors can easily fall into the trap of believing they have reduced their portfolios’ risk through diversification.

“Whenever they see lots of line items in a portfolio, they think they’re diversified,” he said. “There can be an overestimation or a misunderstanding of the level of diversification that that portfolio actually contains.”

An investor holding two or three different equity funds may have only “paper-based” diversification, he said. “You’re just owning the same risk exposure a bunch of different ways.”

The effect of concentration is particularly pronounced in the United States, where the 10 biggest constituents of the S&P 500 make up more than 39 per cent of the index, and nine of those are in tech or tech-adjacent sectors.

But even in Canada, where the benchmark S&P/TSX Composite is dominated by financials, materials and energy companies, the top 10 names account for around 38 per cent of the index.

Investors hoping to diversify by going global may also find themselves more concentrated than they realize. The U.S. accounts for nearly three-quarters of the MSCI World Index, which features more than 1,200 constituents across 23 developed markets.

Index concentration has had its benefits. In the first half of 2026, 67 per cent of actively managed U.S. large cap equity funds underperformed the S&P 500, and over the past five years 89 per cent have lagged the index, according to S&P Global. Mr. Vatvani said many investors looking at their index returns may not see any reason for concern.

“But if you start to look under the hood, there’s lots of warning signs,” he said. More than 40 per cent of S&P 500 components have fallen this year, Reuters reported last week, despite the rise in the broader index.

It’s not just passive investors tracking indexes that are susceptible to concentration risk. Steve Sosnick, chief strategist at Greenwich, Conn.-based Interactive Brokers, said customers had been steadily buying technology stocks through recent market pullbacks.

“They see every dip as a buying opportunity,” he said, likening stock markets to a building that is not yet on fire.

“Investors have done very well by rushing in where it’s just merely smoldering,” he said, describing a perception among investors that AI has “limitless potential” and will yield robust returns.

That perception in part reflects the scale of AI-related spending. In an interview, Jonathan Lo, portfolio manager at Toronto-based Ninepoint Partners, compared the US$800-billion in expected artificial intelligence capital expenditure this year and US$1-trillion next year with the US$700-billion Troubled Asset Relief Program introduced in 2008 to rescue the U.S. economy from the global financial crisis. AI capital expenditures, he said, have powered markets higher.

But Mr. Sosnick cautioned that with most institutions already fully invested in AI and tech names, the coming earnings season may see a tepid market response to even strong results.

While there is a risk that index concentration could exacerbate the effects of a reversal in market sentiment, experts say the history of concentrated markets should provide some comfort for longer-term investors.

“The statistical relationship between market concentration and future returns in the U.S. market has been very, very slightly negative in economic terms and statistically insignificant,” said Benjamin Felix, chief investment officer and portfolio manager at Montreal-basedPWL Capital.

Mr. Felix highlighted the example of Nortel Networks, which at its peak accounted for more than a third of the Canadian market, before collapsing in 2009.

“It went bust, as we all know, and eventually went to properly zero, and the Canadian market outperformed the U.S. market through the tech crash and the lost decade that followed.”