Is Your Index Fund Really Diversified?

A total stock index fund owns thousands of individual stocks. For example, the Vanguard Total Market Index Fund ETF VTI

owns 3,498 companies, and the Fidelity Total Market Index Fund FSKAX owns 3,741 companies. Most nonindex funds own between a few dozen and a few hundred companies.

For most of my career in financial planning, I’ve been saying these total US stock index funds are as diversified as one can get in US stocks. I’m now rethinking my position due to market concentration. In fact, Vanguard discloses the following on its website for Vanguard Total Stock Market ETF:

Nondiversification risk: Because the fund seeks to closely track the composition of the fund’s target index, from time to time, more than 25% of the fund’s total assets may be invested in issuers representing more than 5% of the fund’s total assets due to an index rebalance or market movement, which would result in the fund being nondiversified under the Investment Company Act of 1940. The fund’s performance may be hurt disproportionately by the poor performance of relatively few stocks, or even a single stock, and the fund’s shares may experience significant fluctuations in value.

As of March 31, 2026, the top 10 positions account for about 34% of these total stock index funds. That means that 0.3% of the issuers represent more than one-third of the total value because total market index funds are all capitalization weighted. That is, the companies are weighted according to the total market value of their outstanding shares.

What Is Diversification?

Investopedia defines diversification as “a risk management strategy that creates a mix of various investments within a portfolio. A diversified portfolio contains distinct asset types and investment vehicles in an attempt to limit exposure to any single asset or risk.”

One stock, Nvidia NVDA, represents about 6.2% of the Vanguard Total Stock Market ETF as of Feb. 28. Technology and communication-services sectors represent about 41% of this fund. I’m including communication services because that sector comprises stocks like Alphabet GOOGL and Meta Platforms META, which are heavy in technology and include AI.

Is Equal Weighting More Diversified?

Funds don’t have to be weighted by market capitalization; each company could be weighted equally. This probably wouldn’t work for a total stock index fund because the Vanguard Total Stock Market ETF would likely have to buy more shares of the smallest companies than are actually outstanding. But equal-weighted S&P 500 funds exist, such as the Invesco S&P 500 Equal Weight ETF RSP. RSP’s largest single position relative to its portfolio is 0.28%. For comparison, the largest position of the cap-weighted Vanguard S&P 500 ETF VOO is 7.31%. Invesco S&P 500 Equal Weight ETF has 22.5% of its portfolio in technology and communication services. Vanguard S&P 500 ETF has 43.9%.

Though I’m certainly not arguing that an S&P 500 index fund is more diversified than a total stock index fund, one could buy an equal-weighted S&P 500 fund and a cap-weighted extended market index fund, which owns virtually all of the US stocks not in the S&P 500. Is that more diversified? At first, it appears that equal weighting the S&P 500 combined with the extended market index fund is more diversified.

But weighting the least valuable companies the same as the most valuable results in owning many times the market value of the smallest companies in the S&P 500 and bets against those that are the largest. Making large bets against the market certainly doesn’t strike me as wise.

The Purpose of Diversification

Before deciding on whether a total stock index fund is truly diversified, let’s look at why we diversify. According to Investopedia, diversification is the process of spreading investments across different asset classes, industries, and geographic regions to reduce the overall risk of an investment portfolio.

Morningstar’s review of Invesco S&P 500 Equal Weight ETF says it suffers from high turnover and high volatility because it assigns the same weight to every S&P 500 stock. The higher volatility is exactly counter to the purpose of diversification. Higher fees and higher costs from turnover also increase risk because costs reduce the probability of getting total market returns.

I asked Edward McQuarrie, professor emeritus at Santa Clara University, about diversification as it relates to total market index funds. He said there are many different definitions of diversification and pointed me to Nobel Laureate William Sharpe’s definition. Sharpe said:

“We teach in beginning finance classes that in an efficient market, the only kind of risk that’s rewarded with higher expected long-term returns is risk you can’t get rid of by diversification. We call this market risk. A sensible proxy for this overall market is a portfolio of all the traded bonds and stocks in the world, held in proportion to their outstanding shares or bond issues. If you own all these securities, you have diversified as much as you can."

My Conclusion

There are certainly arguments that the current market concentration in a handful of companies makes a total stock market index fund less diversified than in the past. I also admit that I’m uncomfortable with the current market concentration in mega-cap stocks. But if the purpose of diversification is to reduce risk, I know of no other more diversified US stock fund than a total stock index fund.

Of course, a truly diversified portfolio needs to include international stocks as well as fixed income. Cap-weighted index funds also work here.

I certainly admit that I’m not smarter than the market. One can either buy a cap-weighted total stock index fund and harness all of the investor information that went into pricing each stock and earn the market return, or one can bet that markets are inefficient and take the risk that they can outsmart the market. I’m sticking with cap-weighted total stock index funds.