In recent years, the stock market has witnessed the remarkable rise of a small number of giant technology companies, which now hold a significant portion of major indexes such as the S&P 500 and the Nasdaq-100. Notably, five companies, namely Apple, Microsoft, Amazon, Nvidia, and Alphabet, account for approximately 25% of the S&P 500, while six companies, including Apple, Microsoft, Amazon, Nvidia, Alphabet, and Broadcom, comprise around 40% of the Nasdaq-100. This concentration raises concerns over the potential risks associated with such dominance.
S&P 500 and Nasdaq-100 undergo periodic rebalancing to adjust the composition of their respective indexes. This routine event coincides with other significant trading activities, such as triple witching, which refers to the quarterly expiration of stock options, index options, and index futures. The period after triple witching is crucial for tax loss harvesting or positioning for the upcoming year. Consequently, trading volume tends to decline by 30%-40% in the final two weeks of the year, with the final trading day exhibiting notable volume. While these events may seem of academic interest, they hold greater importance for investors due to the increasing trend of passive index investing.
The rising popularity of passive index investing has led to a substantial amount of money being allocated to mutual funds and ETFs directly or indirectly tied to major indexes, particularly the S&P 500. According to Standard & Poor’s, approximately $13 trillion is directly or indirectly indexed to the S&P 500. The three largest ETFs, namely SPDR S&P 500 ETF Trust, iShares Core S&P 500 ETF, and Vanguard S&P 500 ETF, collectively manage nearly $1.2 trillion in assets. Additionally, the Invesco QQQ Trust (QQQ), linked to the Nasdaq-100, stands as the fifth-largest ETF with approximately $220 billion in assets under management. Therefore, any adjustments in the indexes can trigger substantial movement of funds in and out of these investment vehicles.
As part of the rebalancing process, the weighting of each stock in the S&P 500 is adjusted to account for changes in share count. Companies often engage in share buyback programs to reduce share count, resulting in a decrease in their weighting within the index. This quarter, Apple, Alphabet, Comcast, Exxon Mobil, Visa, and Marathon Petroleum will see their share counts reduced. Consequently, funds indexed to the S&P 500 will have to decrease their weighting accordingly. On the other hand, other companies such as Nasdaq, EQT, and Amazon will experience an increase in their share counts, leading to an increase in their weighting within the index. The adjustments also involve the addition and deletion of companies from the index. Uber, Jabil, and Builders FirstSource will be added to the S&P 500, while Sealed Air, Alaska Air, and SolarEdge Technologies will be removed and moved to the S&P SmallCap 600 index.
The Nasdaq-100 undergoes rebalancing four times a year, with the annual reconstitution occurring exclusively in December. Recently, Nasdaq announced six additions to the Nasdaq-100: CDW Corporation, Coca-Cola Europacific Partners, DoorDash, MongoDB, Roper Technologies, and Splunk. Simultaneously, six companies, namely Align Technology, eBay, Enphase Energy, JD.com, Lucid Group, and Zoom Video Communications, will be removed from the index. The reconstitution process aims to maintain diversification and address overconcentration risks.
Under federal law, diversified investment funds, including mutual funds and exchange-traded funds, must adhere to certain diversification requirements. These requirements ensure that no single issuer accounts for more than 25% of the total assets of the portfolio. Additionally, securities representing more than 5% of the total assets cannot exceed 50% of the portfolio. Major indexes, such as the S&P sector indexes, impose similar rules to maintain diversification. For instance, the Technology Select SPDR ETF (XLK) follows the rules that prevent a single stock from exceeding 24% of the float-adjusted market capitalization of the sector index. Moreover, the sum of companies with weights greater than 4.8% cannot exceed 50% of the total index weight. If the prices of certain stocks hold steady by the close on Friday, there may be slight reductions in the weightings of Apple and Microsoft within the Technology Select Sector index.
The overwhelming dominance of a few companies in major indexes has sparked debates regarding market concentration and its potential consequences. Notably, Nasdaq took special measures in July to rebalance the Nasdaq-100, reducing the weightings of large tech stocks such as Microsoft, Apple, Nvidia, Amazon, and Tesla. Whether market concentration rules should be tightened remains subject to ongoing discussions. Interestingly, the percentage of the five largest companies in the S&P 500 was also around 25% in the 1970s, suggesting that the issue of concentration has persisted over the years.
Stock index rebalancing plays a crucial role in maintaining the diversification and stability of major indexes. The dominance of a select few technology giants adds an additional layer of complexity to these rebalancing activities. As more investors opt for passive index investing, the impact of these events becomes increasingly significant. The movements of funds within mutual funds and ETFs linked to these indexes can drive substantial changes in the market. It is important for investors to closely monitor these events and understand their potential implications.