August 01, 2024

Talkin’ ‘bout Your Concentration: The Risk of Passive ETF Investing

A lot of ink has been spilled over the stranglehold that the “Magnificent 7” has over the S&P 500 index and for good reason: companies like Nvidia, Microsoft, Apple, Meta, Alphabet, and Amazon have driven the majority of index returns this year. In our view, the extreme concentration in that market creates potential risks that undercut the diversification benefits. Additionally, what is perhaps surprising to some (us included) is that for those who want to huff the high-octane a bit more by buying a sector ETF like the Technology Select Sector SPDR® Fund (XLK), what you see is not what you get.

This post aims to do a couple of things: (1) illustrate that passively owning the US market through an ETF like Standard & Poor’s SPDR S&P 500 Trust (SPY) is more like a momentum trade on growth stocks rather than a diversified investment in the entire economy, lacking the safeguards of an actively managed portfolio; and (2) highlight a quirk in the structure of at least one ETF that has some diehard investors upset due to the large tracking error it creates versus its underlying target.

First, a word on the S&P 500’s concentration.

The S&P 500 is far more concentrated today than it was even during the Tech Bubble years.

Recently, concentration in the S&P 500 has risen to the point that the seven largest stocks currently comprise 30% of the index. Compare that to the 1999-2000 Tech Bubble, when the largest seven reached “only” 22%. See Figure 1. 

Figure 1: Largest 7 Issuers’ Weight in the S&P 500 – Tech Bubble vs Last 6 Years

Readers of this post may remember all too vividly the post-pop years of 2000-2002, when the S&P 500 returned -10%, -13%, and -23%. As we write in early August 2024, the “CNBC Magnificent 7 Index” is down -11.8% since its peak July 9, with half of those losses occurring in the last few days. History tells us a week or month does not a trend make – especially with the Mag 7 – but it’s a reminder that what goes up can come down. And if you’re not positioned to defend against downside risk, you assume it all.

The one-sector dominance within the S&P 500 means owning it is equivalent to putting on a momentum trade on growth stocks.

To be fair, 2024 is not 1999. Much of the big price moves by technology stocks can be justified with strong earnings over the last year – notably Nvidia, which has accounted for about one-third of the S&P 500’s gains in 2024. JP Morgan is more sanguine in its expectations for the group, forecasting Mag 7 earnings per share (EPS) growth to decelerate from +50% year-over-year in Q1 2024 to +17% by Q4 2024. Meanwhile, earnings from the Bottom 493 are expected to accelerate from -2% EPS growth in Q1 2024 to +17% by Q4 2024. Whatever the outlook, the sheer dominance of these tech names means owning the index is more of a momentum-growth play on technology than a well-diversified strategy.

Exactly how diversified is the S&P 500? One way to measure stock concentration risk is by calculating what’s called an index’s “Herfindahl–Hirschman Index,” which estimates the equivalent number of stocks, held in equal weights, that would mimic the concentration level of the index.

Based on this calculation, owning an S&P 500 ETF like SPY is equivalent to holding about 49 stocks (source: Bloomberg and Leith Wheeler estimates). That’s not too bad, you might say, and indeed many Leith Wheeler equity strategies hold around this number of stocks. However, unlike the index, we apply prudent price and risk management, portfolio construction, and sell disciplines to these strategies. We own companies we believe in and manage concentration of risks.

Many of these Mag 7 companies are fantastic businesses and market leaders who are driving technological innovation. With that being said, a great business is not always a great investment. A great investment requires a price differential between what you can pay today and what you can ultimately sell it for (i.e., the profit). As such, we remain disciplined in our value approach and prefer to own high quality businesses generating strong cash flows at reasonable valuations (which can include Mag 7 companies from time to time). Unlike an active manager, a passive ETF will not be taking profits from the strong performers, nor reflecting on the fortunes of the majority of the smaller companies, whether or not they’re undervalued and/or growing. ETF investors get a ticket on the ride without a safety bar.

Let’s look at one of the rides that’s made for adrenaline junkies: the Technology Select Sector SPDR® Fund (XLK).

The devil is in the details: Guardrails to preserve diversification deliver a shock to sector ETF holders.

XLK’s mandate is to hold the constituents of the S&P 500 Technology sector – but to stay onside of regulations governing concentration, index ETF provider State Street cannot just own the stocks in their pro-rata index weights. Instead, it has limits on maximum size / exposure and must regularly rebalance the product, which has caused the ETF to lag its underlying sector benchmark by over 10% this year through June.

This surprised some investors and a recent article that caught our attention highlighted what happened when in late June, XLK had to purchase a large block of Nvidia shares and sell a big chunk of Apple as part of its rebalancing regime. Figure 3 shows the dramatic rebalance trade that the $68 billion ETF had to undertake – remarkable not only for the sheer size of the trade but also for the wild swings in weights that it involved.

Figure 3: Technology Select Sector SPDR Fund (XLK) June 2024 Estimated Rebalance Trade

Seeing both the before and after weights of the big holdings, it is unsurprising that the ETF underperformed – not just because the weights differed from its reference sector index, but because over the six months heading into that rebalance, high-weight (22.0%) Apple had underperformed while low-weight Nvidia (5.9%) largely outperformed. Counterintuitively (for an active manager), the ETF rebalance then added to Nvidia at close to all-time highs and sold Apple far off its all-time highs due to its recent underperformance. This looks suspiciously like a sell-low, buy-high strategy in the short-term.

Figure 4 shows the lag over those six months. If you look back up at the right columns in Figure 3, you can also see how Apple and Nvidia have fared since the rebalance. The timing of the ETF rebalance has indeed proven poor, at least over the short weeks that have followed.

Figure 4: XLK underperformed the S&P 500 Technology Index by 10% YTD through June

Passive ETFs can be an efficient, low-cost vehicle to gain exposure to markets or sectors, but they can carry unique risks – especially right now in in the US. Broad market indices like the S&P 500 do not protect investors from concentration risk and at the other end of the spectrum, investors seeking hyper-charged concentration aren’t getting that, either.

At Leith Wheeler, we build portfolios comprised of material weights in our best ideas, managed to balance risks while offering the opportunity for long-term outperformance. It’s an approach designed to preserve and grow capital through both good and bad markets. As the Mag 7’s magnificence is tested in the coming years, this feels like a preferable place to be.

Matt Kidwell

Portfolio Manager - Private Clients & Foundations

Mike Wallberg

Principal, Head of Marketing & Communications