
U.S. stock market concentration is, by some measures, at record levels. As of mid-2024, the S&P 500 has more than 20% of its value in just three companies Microsoft, Apple, and Nvidia; about 33% in the top ten. It has become increasingly popular in the financial press to spread concentration concerns about high prices of and lack of diversification from these stocks, speculating whether this will end badly for investors. On the other hand, there are plenty of media reports to the contrary as to why the concentration is not only justified but that this time is different.
Only time will tell the ending to this risk and concentration story. However, the lack of a crystal ball does not give a pass on responsibility for a sound investment process. Process drives outcomes over time. And part of a prudent process is knowing what you own. Below considers some related matters to the market’s concentration that are not commonly understood.
Fund Regulations
Most households rely on funds to invest in the stock market. These funds are generally mutual funds or exchange traded funds (ETFs), which are registered under the Investment Company Act of 1940. As such, these funds have diversification requirements they must adhere to. Within these requirements funds can elect to be “non-diversified” or “diversified” with specific regulations thereunder.
From the Investment Company Institute, “U.S. funds are required by federal tax laws to be, among other things, diversified. If a fund elects to be diversified for purposes of the Investment Company Act (and most do), the requirements are more stringent (than if ‘non-diversified’ is elected)—with respect to 75% of its portfolio, no more than 5% may be invested in any one issuer.” To do the math, 75% multiplied by 5% equates to 3.75%. Microsoft, Apple, and Nvidia are roughly 7% each of the S&P 500.
While these regulations get a bit wonky, it’s easy to see that market concentration presents an issue for funds – particularly those that elect to be “diversified.” Many funds are thus re-registering from “diversified” to “non-diversified”, which may impact their investment strategy. And when you look further into the strategy of the fund as to whether funds seek index-like returns or pursue more actively managed strategies to seek enhanced returns, each has its own twists.
Index & Active Strategies
Concrete examples are often great teachers. On June 21, 2024, the S&P Technology Select Sector Index, which several ETFs track, executed its annual rebalance. The event was notable for some significant stock weight changes motivated by diversification constraints.
For many of these ETFs, specific regulations under the 1940 Act that applied have that the combined weight of security positions with at least 4.8% weight in the index cannot exceed 50% of total assets.
One solution to avoid breaching the 50% limit is to trim the weights pro rata from all the stocks over 4.8% until the combined total falls below 50%. S&P’s index methodology, however, dictates a different approach. The excess over 50% is trimmed entirely from the smallest of the group.
The combination of Microsoft, Apple, and Nvidia already triggered this clause in 2023. The difference in 2024 is which stock is the smallest of the group. Last year, it was Nvidia, meaning it was held at substantially lower weight than Microsoft or Apple to satisfy the combined weight limit. This year, Apple was the smallest of this trio.
“Smallest” is a relative term, though. All three had market values above $3.29T and, as of June 18, were within $50,000 of each other. But rules are rules—double-digit weight was transferred from Apple to Nvidia on the rebalance date. Said another way, Apple went from being about 22% of the index to 5% after the rebalance while NVIDIA went from 6% to 20%. This huge change then flowed into those ETFs that tracked the index, as the ETFs sold Apple to buy Nvidia.
Changes in portfolio composition this dramatic relative to underlying market movements can happen when arbitrary rules are applied with dogmatic adherence. That’s one of the drawbacks of index fund processes and one that highlights the potential benefit from flexibility in investment decisions.
For actively managed strategies, these funds must also follow diversification requirements under the Act but do allow for more flexibility than the index example above. Despite this flexibility, active managers are somewhat tied due to the structural makeup of the market as a result of its concentration.
Institutional consultant Callan wrote in February 2024, “(Concentration) both in weight and (performance) attribution, affected just about every large cap portfolio (in 2023). Investment managers, regardless of whether they were concentrated or diversified, saw their upside participation challenged, particularly for those with zero weights or underweights to names.”
What To Do
Some may be thinking, “I’ll just buy individual stocks rather than funds.” There are decades of evidence that this will not likely work well for professional managers and consumers alike. From Morningstar on two professional examples:
One recent example is Baron Partners BPTIX, whose gargantuan stake in Tesla TSLA—recently more than half the portfolio’s assets—powered its extraordinary results from 2020-21 but sapped them in 2022 when the electric vehicle maker plunged by two-thirds. Sequoia SEQUX suffered an infamous blowup from 2015-16 as the market value of its biggest holding, then known as Valeant Pharmaceuticals, collapsed and never recovered.
These are not only examples of stock-picking going awry but also of the risks of concentration. Do you want to bet your life savings or your retirement security by overconcentrating?
Most prudent investors choose not to overconcentrate. Rather, as Nobel Laureate Merton Miller said, “Diversification is your buddy.” Yet, with the highly concentrated U.S. market and structural implications that result from it, more prudence and skill are required to obtain it. Given this, it is likely a good time to get a second opinion on your investing process.
Kevin Kroskey, CFP®, MBA | July 2024
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This article adapted with permission from Dimensional.com