Providers of major US stock benchmark indices are considering reducing the weight of large-cap companies in key indices due to the prosperity of tech giants. Faced with the dominance of companies like NVIDIA and Apple, FTSE Russell and S&P Dow Jones plan to set upper limits on the weights of constituents in their products to address the issue of over-concentration of tech stocks in investment portfolios. This move has sparked criticism of passive investment strategies and calls for regulatory restrictions to prevent over-concentration of investments. The consultation phase for these proposals will continue until August 30, with changes potentially taking effect on September 23
According to Zhitong Finance, the prosperity of tech giants is causing headaches for the providers of the benchmark indices in the US stock market. As companies like NVIDIA (NVDA.US) and Apple (AAPL.US) increasingly dominate, the US stock market is becoming more and more unbalanced. The two largest component stock companies in the world—FTSE Russell and S&P Dow Jones Indices—are considering plans to reduce the weight of large market cap companies in key indices.
As the holdings of many portfolios in the largest tech stocks begin to exceed regulatory limits, investors across industries are forced to make adjustments. The pressure on these two index giants is also increasing, with their products collectively tracking $35 trillion in investments.
These proposals provide new reasons for critics of the passive investment trend. For a long time, these individuals have pointed out that this strategy is more active than it appears on the surface. Any adjustments to the indices expose the hidden human factors behind the benchmarks. Antti Petajisto, stock director at Brooklyn Investment Group, said, "Most investors may not realize that there is some degree of active element even in what we think of as passive strategies."
The consultation period for Russell will end on August 30 without a set implementation schedule; the consultation involves setting limits on the weight of the largest component stocks in its widely followed US growth and value indices. S&P's consultation will end on Friday, focusing on adopting a new approach to limiting the proportion of component stocks in a range of industry measures, with these changes set to take effect on September 23.
Behind these proposals are long-standing rules for regulated investment firms that limit the proportion of any security in a portfolio to within 25% and the total weight of the largest holdings (with a stake of 5% or more) to within 50%. In the industry, this is commonly referred to as 25/5/50. These limits are set to prevent investors from overly concentrating their investments in certain companies, but in the current market where companies like Apple and NVIDIA continue to grow, these restrictions may penalize investors.
Last month, the top 10 component stocks of the Russell 1000 Index—mainly tech stocks—accounted for 34% of the index. Although this has not yet reached the 25/5/50 level, it is a level of concentration never seen in the 45-year history of the index.
Russell has already provided a set of capped indices to complement its more traditional unconstrained benchmarks. Catherine Yoshimoto, Managing Director of FTSE Russell's product management under LSEG, said that consideration is currently being given to whether to set limits on the weightings of its standard style indices. Over $7 trillion in assets are benchmarked against the company's style indices. She said, "For example, some clients are indeed urging us to consider setting limits for the standard Russell 1000 Growth Index.
Over the past 20 years, passive funds have been snatching market share from active investment competitors, thanks to their low costs and people's negative impressions of stock pickers. However, some market participants like to point out that this index reform is not as radical as it seems.
This view believes that top-down decisions are made by humans at almost every stage of the "passive" strategy, whether it is writing index rules, deciding how to apply them, designing funds that track benchmarks, or actually executing trades. For example, contrary to many people's assumptions, the S&P 500 Index—the main benchmark index of the world's largest stock market—does not only include the largest 500 companies in the United States. Its members are selected by a group of anonymous index experts.
The reform proposals put forward by S&P and Russell highlight the types of interventions to prevent violations and the differences that may arise between companies as a result. In compliance with the 25/5/50 limit, index managers use different mechanisms to limit the weights of companies and different trigger mechanisms (although they typically choose levels slightly below 25/5/50 to provide a buffer). For example, Russell proposed an upper threshold of 20/4.5/48 in its proposal, which is different from the Nasdaq 100 Index and the S&P Index, whose upper thresholds are 24/4.8/50. Russell's Yoshimoto stated that these differences may reflect different approaches to ensuring the best way to reduce the likelihood of regular violations.
At the same time, in order to limit the weights of constituent stocks, indices such as the Nasdaq 100 Index often proportionally reduce holdings of top holdings. However, when some stocks exceed the upper limit of the S&P Industry Index, the smallest stocks are first cut, suppressing their weight in the index and leaving investors underexposed.
In the first half of this year, when NVIDIA's stock price soared, funds such as the Technology Select Sector SPDR Fund (XLK.US) under the umbrella of DWS Global Investments experienced this situation. These regulations meant that XLK reduced its holdings of the stock, causing the ETF to lag behind the tech stock benchmark without this rule by 10 percentage points—the worst performance on record.
Then, when NVIDIA surpassed Apple in June, it triggered a rebalancing, with XLK sacrificing the iPhone maker to purchase around $11 billion worth of NVIDIA shares. Now, their positions are reversing again, and XLK faces the risk of another major reshuffle. If the current rankings hold until the next quarterly rebalancing in September, then according to the existing method, NVIDIA's weight in the fund may have to drop from 21% to 4.5%, while Apple's weight could surge from 4.8% to 22% Edward Yoon, a capital index expert at Macquarie, stated that S&P's proposed adjustment aims to reduce the frequent high turnover rate. The index's owners suggest that instead of targeting the minimum individual stocks that violate the principle of diversified investment, it is better to limit them according to the market value proportion of all holdings.
According to Josh Kutin, Head of North American Asset Allocation at Columbia Threadneedle Investments, regardless of the negotiation outcome, it is definitely not a bad thing because it will help investors deal with the challenges brought by the increasingly concentrated market. He said, "Asset allocators are obsessed with diversified investment, so the more concentrated our portfolios are, the more uncomfortable we feel. I support reducing the reliance on market value in index construction, even if it is a human decision rather than a market mechanism."