The passive fund risk investors need to be aware of

A narrow set of winners in an index over a certain period results in those companies becoming more influential. This is currently the case in America’s S&P 500 index, with the so-called Magnificent Seven technology stocks having a weighting of nearly 30%.

The seven stocks dominating US and global markets are: Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), Apple Inc (NASDAQ:AAPL), NVIDIA (NASDAQ:NVDA), Meta Platforms  (NASDAQ:META) and Tesla(NASDAQ:TSLA).

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Last year, the seven stocks delivered “show-stopping performance”, notes Sebastian Lyon, manager of Personal Assets (LSE:PNL) Trust. Lyon adds that the dominance of those companies is underlined by “72% of the remaining 493 constituents of the S&P 500 underperforming the index as a whole, as did many actively managed equity funds”.

However, there is now talk of the spotlight homing in on the “Fab Four”: Nvidia, Microsoft, Amazon and Facebook owner Meta. In the first quarter of 2024, those four stocks outpaced the other three members of the Magnificent Seven. 

Rising share prices since the start of 2023 means those seven companies have become a bigger part of US and global markets. 

A report by Research Affiliates, a company that specialises in predicting the future returns of assets, cautions that this is a “level of concentration not seen in decades” and increases risk due to the index’s fortunes becoming more reliant on big tech continuing to deliver.

Over time, the firm points out, the biggest winners do not keep winning. It notes: “Historically, few market leaders could sustain their dominant position as competitive forces and entropy undermined seemingly secure redoubts. Of the largest 10 stocks globally at the start of each decade, only two at most (and often only one) were able to defend their position a decade on.”

The research report adds that “shifts in expectations can create explosive compressions in valuations, quickly erasing gains”.

It adds that the way most indices are constructed, using market-cap weightings that rank companies by size, is “vulnerable to flights of fancy by investors”. It continues: “Current levels of concentration only heighten that risk. While markets are semi-efficient over the long run, prices over the short run reflect some degree of error.”

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How to reduce the risk of the Magnificent Seven?

This leads to the question, how can investors reduce the risk of having too many eggs in the technology basket? One option is an equal-weighted index, which holds each company in equal proportion. For example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

One of the main benefits of this approach is that investors avoid being overexposed to stocks that have become overvalued or, worse still, potentially part of a bubble. Another plus point is that an equal-weighted index offers more exposure to parts of the market that have performed less well in recent years. Going forwards, if there’s a broader set of winners in US markets, this approach can, in theory, capitalise on that more than market-cap weighted indices.

There are a shortage of equally weighted options for the S&P 500 index, but among them are Invesco S&P 500 Equal Weight ETF, iShares S&P 500 Equal Weight ETF and Xtrackers S&P 500 EW ETF.

Another option, which Research Affiliates advocates due to specialising in this area, are so-called smart beta indices. Rather than weighting companies by their size or adopting an equally weighted approach, these indices use alternative measures by screening for dividends, value, momentum, quality, volatility or earnings growth. 

This approach aims to offer a middle ground between active and passive funds. Monika Calay, director of manager research at Morningstar, explains that“most seek to enhance returns or minimise risk relative to more traditional benchmarks”.

Calay adds: “Others seek to address oft-cited drawbacks of standard benchmarks, such as the negative effect of contango in long-only commodity futures indexes, and the overweighting of the most indebted issuers in market-value-weighted fixed income benchmarks.”

Examples of smart beta ETFs for the US market include: iShares Edge S&P 500 Minimum Volatility ETF, SPDR® S&P US Dividend Aristocrats ETF and WisdomTree US Quality Dividend Growth ETF.

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How some passive funds are betting big on US tech    

An index fund or ETF tracking the S&P index on a market-cap weighting basis will have around 30% in the Magnificent Seven, such as Vanguard S&P 500 UCITS ETF and iShares Core S&P 500 ETF. Both have low yearly ongoing charges of 0.07% a year.

Naturally, a technology-focused passive fund will have higher weightings to the seven companies. L&G Global Technology Index, for example, has a 17% weighting to Microsoft, 13.5% to Apple and 11.7% to Nvidia.  

Invesco EQQQ NASDAQ-100 ETF (LSE:EQQQ) has smaller individual weightings, with its top holding, Microsoft, accounting for 8.6%. However, its overall exposure to those seven companies accounts for 41%.

Another passive fund with big weightings to the US technology behemoths is L&G Global 100 Index Trust. The index it tracks holds multinational blue-chip companies of “major importance” in global equity markets. The end result for L&G Global 100 Index Trust is big weightings to five of the Magnificent Seven: Microsoft (accounts for 12.4% of assets), Apple (9.8%), Nvidia (8.8%), Alphabet (6.5%) and Amazon (6.5%).

Other global index funds and ETFs hold less in US tech. For example, Fidelity Index World has in its top 10 holdings just over 18% collectively in Microsoft, Apple, Nvidia, Amazon, Alphabet and Meta Platforms.

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Active funds tend to be ‘underweight’ the Magnificent Seven

Most actively managed US and global funds tend to hold less than the wider market in the US technology giants. One reason why is due to portfolio concentration rules, which prohibit funds from holding more than 10% in a single stock. Whereas, index funds and ETFs can hold a higher percentage.

In the case of index funds, 20% of assets can be held in a single stock, which can rise up to 35% in exceptional market conditions. For ETFs, the same 20% rule applies, but some put their own rules in place to cap each constituent at a certain level, such as 10%.

Such rules are in place to ensure funds are sufficiently diversified, which helps to reduce risk.   

For investment trusts, there is no single-stock limit. However, in practice, most investment trusts don’t continually hold more than 10% in a single stock and it is rare to see a position of 15% or more. Some investment trusts have their own stock position rules

As ever, it is important that investors look under the bonnet and understand how much concentration risk they are exposed to. A look at the top 10 holdings will provide a quick snapshot.