Commonwealth Bank of Australia (ASX: CBA) shares have garnered significant attention lately.
And for good reason.
CBA has risen 43% in the past 12 months.
With a price-to-earnings ratio (P/E) over 30, they are considered the most expensive banking stock in the world.
Most active fund managers have avoided or are underweight the ASX 200 banking stock, and the majority of analysts have placed sell recommendations on it.
In a 3 July research note covering the big 4 banks, broker Macquarie Group Ltd (ASX: MQG) reiterated its underperform rating and $105 price target on CBA shares.
Safe to say, investors have been sufficiently warned to steer clear of CBA shares.
However, given CBA's large weighting in the S&P/ASX 200 Index (ASX: XJO), there are other potential consequences of CBA being significantly overvalued.
What could happen?
Following its record run, CBA accounts for around 12% of the ASX 200 Index. For reference, the next largest holding is BHP Group Ltd (ASX: BHP), which accounts for around 7% of the index.
Those buying index funds such as the BetaShares Australia 200 ETF (ASX: A200), which mimics the ASX 200 Index, therefore have large exposure to CBA shares.
How could a large decline in CBA shares impact the ASX 200 Index?
A recent article in the Australian Financial Review contemplated that very scenario.
According to MST Marquee strategist Hasan Tevfik, the ASX 200 would fall 5% if CBA returned to 'normal valuations'.
Tevfik said the ASX 200 would fall 460 points if CBA traded on a P/E of 16 times, which is its historical average.
While there may be some discrepancy in analyst price targets, with some likely to argue that the stock has improved in quality and deserves a higher valuation, most analysts would agree that CBA shares are worth a lot less than they are today.
Therefore, a decline in the CBA share price would impact not just individual CBA investors but also those invested in index funds.
Foolish Takeaway
Earlier this week, I explained that the ASX 200 had become increasingly concentrated. As a result, the A200 ETF is far less diversified than investors may be led to believe. Yesterday, in an Australian Financial Review article, an MST Marquee strategist, Hasan Tevfik, crunched the numbers and put a figure on the potential consequences of CBA's valuation.
To reduce risk, one option is to reallocate some funds to equally weighted ETFs such as the VanEck Australian Equal Weight ETF (ASX: MVW). As the name suggests, its 74 allocations are equally weighted. So, while it does hold CBA shares, they are weighted the same as the 70 other holdings. Should CBA shares return to 'fair value', the MVW ETF is likely to hold up much better than the A200 ETF.
