That’s The Takeaway from this morning’s Brief, which you can do register to receive in your inbox every morning along with:
Nvidia (NVDA) posted its 43rd record close on Tuesday, bringing its return to 2024 close to 175%.
Unfortunately, passive investors who rely on mutual funds and ETFs as investment vehicles have not been able to partake in all of these benefits.
Micron ( MU ), Qualcomm ( QCOM ), KLA Corp ( KLAC ) and Lam Research ( LRCX ) also closed at all-time highs on Tuesday, catapulting the broader S&P 500 technology index to its record high and increasing his year to -date returns an enviable 31%.
But its closest investable match — the Technology Solutions Sector SPDR Fund ( XLK ) — is underperforming the technology sector benchmark by more than 10 percentage points this year.
And the issue arises from the very success of the biggest tech names.
The heart of passive investing is based on risk management through diversification. In theory, a diversified technology index is “safer” than one in which three stocks dominate the index.
But over the past four years, Apple ( AAPL ), Microsoft ( MSFT ) and Nvidia have so thoroughly beaten the rest of the market that ETFs are facing rules and regulations that limit the weight of individual stocks in funds.
In theory, each of these three giants should be weighted at just over 20% of the XLK fund – if it meets the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only makes up 5.9% of the ETF.
This situation will soon change – drastically. With it, however, another complication will arise: Apple’s weight will drop significantly.
After Friday’s close, the XLK ETF will be rebalanced to reduce Apple’s 22% stake to 4.5% and increase Nvidia’s 5.9% stake to 21.1%, based on Bloomberg estimates.
This all stems from Great Depression-era investor protection laws, which required indexes to limit the concentration of individual stocks to earn the “diversified” label.
Investors who like to read prospectuses can enjoy the weak legality that explains the need for these changes as expressed in this FAQ and the relevant index methodology published by S&P Dow Jones Indices.
In short, there are four companies — Nvidia, Apple, Microsoft and Broadcom — that exceed the critical 4.8% threshold for individual names in a diversified index. And because they together exceed 50% of the entire weight index, the weights of the smaller members are reduced according to a formula until all legal thresholds are met.
Still, Friday’s rebalancing should force $12.7 billion in Apple shares to be sold and $11 billion of Nvidia to be bought.
That’s close to the dollar amount of Apple stock that trades each day, and about a quarter of the dollar amount that Nvidia trades each day. In other words, these are material amounts.
Fortunately for investors, these are highly liquid stocks, and the investment community will have had a full week to digest the scenario by the time the rebalancing takes effect on Friday.
Of course, there are many companies NO in the trillion-dollar club—and companies that aren’t exactly AI plays—that have rewarded investors handsomely this year.
The Dow Walmart ( WMT ) component is up nearly 30%. GameStop (GME) is up 40%. And shares of Abercrombie & Fitch ( ANF ) have returned 110% this year.
But rebalancing raises the issue of an overlooked risk to the passive investing strategy favored by the masses, which is that they can lose when only a few names are carrying the lot.
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