What does a capped index or ETF mean?

We explain how ETFs and index funds avoid the risk of having too much single stock concentration

Investors in exchange-traded funds (ETFs) and index funds may have come across the term “capped” either in the name or factsheet of funds they are looking at. This means that the index has an upper limit on the weighting of a single stock in the index. For example, the index rules may stipulate that no single stock can account for more than 10% of the index. 

Indices have caps to prevent any single share accounting for too much of the index or the portfolio of the fund that tracks it.

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If any single stock starts to account for more than 10%, or whatever the upper limit is, it exposes the investor to a lot of single stock risk. And for investors in ETFs or index funds, that is often not welcome. As Rumi Mahmood, senior associate of ESG Research at index provider MSCI, notes: “The rationale for a cap in these indexes is to prevent any single stock from exerting a disproportionate influence on the index. In general, this is the main reason for employing capping.”

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However, larger weightings are also not allowed under certain regulations. For example, UCITS funds (which some ETFs are) are not allowed to have more than 10% of their portfolio in a single stock. ETFs under UCITS regulations, therefore, may need to have their exposure to a single stock capped.

Most mainstream indices such as the FTSE 100 and S&P 500 do not cap constituents' weightings. The FTSE 100 or the S&P 500 do not cap constituents. Partly that is because these are flagship indices. They are constructed to represent the market they are supposed to track. A cap would interfere with that.

However, they are also not likely to see a single stock exceed 10%, at least not for long, given their size and diversity. Instead, caps are usually only applied to smaller and niche indices. There are usually two types of indices that are capped. First, those tracking certain themes or sectors, where there are fewer stocks or where one single stock is more likely to dominate. Second, when another screen has already been applied to the index, reducing its size and increasing the risk that one stock will dominate.

Take the VanEck Vectors Semiconductor ETF (LSE:SMH). This ETF tracks the MVIS US Listed Semiconductor 10% Capped Index. This index is composed of the 25 largest and most liquid US-listed semiconductor firms, capped at 10% and rebalanced semi-annually. Any company in the index that has come to account for more than 10% is reduced to this upper limit.

Currently, the index’s largest stock is the Taiwan Semiconductor Manufacturing (NYSE:TSM), at just over 11%. That will eventually be rebalanced to bring it back to 10%. If this didn't happen, Taiwan Semiconductor Manufacturing, being the leading company in the sector, could start to dominate the index.

This is a common risk with sector or thematic indices. However, not all indices use caps. One example is WisdomTree Cloud Computing UCITS ETF (LSE:WCLD), which tracks cloud computing through its own in-house index. Instead of using an upper limit, WisdomTree has opted for a different solution: equal weighting. All constituents of the ETF are held in equal size. That will change as some do better than others. Twice a year the ETF is rebalanced to bring achieve equal weighting.

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Indices that have applied an ESG screen are also likely to apply a cap. This is because when an ESG screen is applied many companies are removed, meaning the weights of those remaining can become bigger. Depending on the index, this can mean large holdings that have not been screened out end up becoming huge.

Take the KraneShares MSCI China ESG Ldrs ETF USD (LSE:KESG). This ETF provides exposure to a basket of ESG-screened Chinese stocks. However, if the ETF had gone for the MSCI China ESG Leaders index, it would end up with an almost 30% weighting to Tencent (SEHK:700) and 28% to Alibaba (NYSE:BABA), meaning together they would account for around 60% of the portfolio, and the ETF would be highly concentrated in just two stocks. 

On top of that, the top 10 holdings account for a collective 81% of the index. In contrast, the MSCI China index’s top 10 accounts for 44%. Tencent and Alibaba also account for around 15% each in that index. This increased concentration is expected when applying an ESG screen. After all, the number of shares falls from almost 700 in the MSCI China index to under 140 in the ESG Leaders index.

As a result, the KraneShares ETF uses the MSCI China ESG Leaders 10/40 Index. This is also an ESG-screened index, which caps individual holdings to 10%, making the index and the ETFs portfolio much less concentrated. As Mahmood notes: “Without the cap limit, the largest companies would collectively dominate the weight of the indexes. Some investors prefer diversification away from a small handful of stocks and applying a cap can resolve this.”