Defending Overconcentration Claims in Index-Driven Equity Markets

“It is the part of a wise man to keep himself today for tomorrow and not venture all his eggs in one basket.” Miguel de Cervantes, Don Quixote (Part II, Chapter 43) (1615)

Sancho Panza dispensed this practical wisdom over 400 years ago, and his sage advice survives as a fundamental tenet of Modern Portfolio Theory. The notion that individual investors should maintain a diversified basket of securities is among the most broadly accepted principles of investing. As Warren Buffett famously said: “Diversification is protection against ignorance.” (Buffett added that diversification “makes little sense if you know what you are doing,” but we can probably ignore that part since most of us are not quite as savvy as the Oracle of Omaha.)

Growing ETF Dominance and the Shifting Landscape of Concentration Risk

In recent decades, investors increasingly seek “ignorance protection” by plowing money into broad-based equity index funds as a core component of their portfolios. Currently, the three largest exchange-traded funds (ETFs) — VOO, SPY and IVV — hold roughly $2 trillion in assets under management, representing a meaningful percentage of the overall US equity market.

Financial advisors (rightly) recommend equity index funds to their clients because these funds offer investors low costs, high liquidity and instant diversification.[1] These benefits are real and durable. And when equity markets turn south, as they invariably do from time to time, recommendations to invest in broad-based equity funds afford brokerage firms and advisors with powerful protection against single-stock and single-sector overconcentration claims in the Financial Industry Regulatory Authority (FINRA) arbitrations that inevitably follow.

As a result, Claimants’ attorneys face a tough journey in their quixotic search for fame, fortune and outsized litigation settlements and awards if they hope to sell FINRA arbitrators on suitability, negligence and overconcentration claims in cases where the equity component of an otherwise well-diversified investment portfolio contains nothing more than broad-based equity funds like the ones noted above. But Public Investors Advocate Bar Association’s (PIABA) best and brightest are not afraid to “dream the impossible dream,” and recent market developments suggest that claimants’ counsel may seek to buttress otherwise weak suitability claims in the coming years with new data showing that US equity indices (and the ETFs designed to track them) have grown increasingly focused on a handful of mega-capitalization names.[2]

For example, market reports indicate that the 10 largest companies in the Standard & Poor’s 500 accounted for nearly 20 percent of that benchmark index in the 25 years from 1990-2015. That figure rose to nearly 30 percent by 2020, and to roughly 40 percent in 2025. 

Strengthening Supervisory Practices Amid Rising Concentration Scrutiny

Investing in a diversified index fund surely does not evidence overconcentration; indeed, the opposite remains true. But the trendline warrants attention.[3] Going forward, plaintiffs’ counsel and regulators may increasingly contend that portfolios comprised of broad-based equity index funds do not offer sufficient diversification if the ETFs are dominated by a small cluster of correlated names.[4] Here are a few strategies to combat these next-generation overconcentration claims.

First, when recommending broad-based equity index funds, broker-dealers and investment advisors may benefit from increasing client engagement and reviewing their supervisory measures lest clients pursue post hoc relief claiming failure to understand the heavily publicized market trends detailed above. Some potential steps could include: 

• Documenting client awareness of existing ETF screening tools, which offer detailed transparency of ETF composition based on issuers, sectors, geography and other metrics.
• Documenting client communications. Recording discussions with clients about their investments and any concentration risk, the structure of major indices, and the potential volatility associated with submarket exposure can be critical in defending later suitability or disclosure challenges.
• Sending acknowledgment letters. “Big Boy” letters are likely unnecessary in most cases, but may be appropriate in unusual circumstances. A well-drafted acknowledgment letter can memorialize client conversations and provide valuable additional evidence documenting the client’s understanding and acceptance of inherent market risks.
• Targeted advisor training regarding concentration risks.

Second, post-dispute strategies are necessarily context-specific but may include emphasizing the (self-evident) principle that a broad-based equity index is “definitionally” well-diversified. If the goal of diversification is “not to venture all one’s eggs in one basket,” then it follows to consider what constitutes a “basket.” In modern equity markets, utilities and consumer staple sectors (among others) simply do not command the same percentage of equity investment capital as they did 20 or 40 years ago, and a well-diversified portfolio should reflect today’s market baskets, not those of the distant past. Thoughtful FINRA arbitrators can be persuaded that a portfolio does not need material exposure to telegraphs (Western Union), typewriters (Smith Corona) or buggy whips (U.S. Whip) to be well-diversified. The market is the market, and if the “eggs” in today’s equity market possess characteristics different than the “eggs” in earlier baskets, the investment solution may rest in having more baskets (e.g., fixed income, alternative investments), not more eggs. Broad-based indexed equity ETFs offer wide-ranging investor benefits, and defense counsel have fertile ground to make a compelling case against faulting financial advisors and firms that refrain from picking winners within the equity market.

Third, the issue is not limited to retail broker-dealers. ERISA fiduciaries, including plan sponsors, investment committees, and 3(21)/3(38) advisors, face similar questions under the duty of prudence and the obligation to diversify plan investments. If a plan’s core menu or qualified default investment alternative is heavily tilted toward cap-weighted US equity indices, fiduciaries should consider whether that structure still satisfies ERISA’s diversification expectations. Regular monitoring, stress testing, and documentation of deliberations around index composition and concentration can be important elements of a prudent process, particularly for plans in which a large proportion of participant assets sit in a single “all-in-one” or index-centric option.

Conclusion

Mega-capitalization issuers have attracted a growing share of U.S. equity markets, and opportunistic claimants’ counsel may seek to exploit that dynamic to raise overconcentration claims against portfolios that contain broad-based indexed equity ETFs. Advisors, broker-dealers and ERISA fiduciaries should recognize this challenge and prepare accordingly.