Rebalancing Raises Concerns
On Friday, the S&P 500 and Nasdaq will be rebalancing their respective indexes, a routine occurrence that carries potential implications for concentration risk. This rebalancing coincides with another significant trading event known as triple witching, which marks the expiration of stock options, index options, and index futures. Following triple witching, trading volume tends to drop by 30% to 40%, with the final trading day showing notable activity.
While these events might seem academically inclined, the surge in passive index investing over the past two decades has increased their importance to investors. When indexes are adjusted, whether through additions or deletions, changes in share counts, or alterations in weightings, substantial amounts of money flow in and out of mutual funds and ETFs tied to these indexes.
Billions Invested in Indexed Funds
According to Standard & Poor’s, nearly $13 trillion is directly or indirectly tied to the S&P 500. The three largest ETFs directly indexed to the S&P 500 – SPDR S&P 500 ETF Trust, iShares Core S&P 500 ETF, and Vanguard S&P 500 ETF – collectively manage almost $1.2 trillion in assets. The Invesco QQQ Trust (QQQ), which is linked to the Nasdaq-100, ranks as the fifth-largest ETF with approximately $220 billion in assets under management.
Standard & Poor’s will be adjusting the weighting of each stock in the S&P 500 based on changes in share count. Apple, Alphabet, Comcast, Exxon Mobil, Visa, and Marathon Petroleum will see a reduction in their share counts, requiring funds tied to the S&P to adjust their weightings accordingly.
On the other hand, companies like Nasdaq, EQT, and Amazon will see an increase in share counts, necessitating an increase in the weightings of S&P 500-indexed funds.
The S&P 500 will also add three companies – Uber, Jabil, and Builders FirstSource – to its index, while Sealed Air, Alaska Air, and SolarEdge Technologies will be dropped to the S&P SmallCap 600.
Changes in Nasdaq-100 Constituents
The Nasdaq-100 undergoes reconstitution only in December, with quarterly rebalancing occurring throughout the year. Nasdaq recently announced that six companies will be added to the Nasdaq-100, including CDW Corporation, Coca-Cola Europacific Partners, DoorDash, MongoDB, Roper Technologies, and Splunk. Meanwhile, six others will be deleted from the index, including Align Technology, eBay, Enphase Energy, JD.com, Lucid Group, and Zoom Video Communications.
Under federal law, diversified investment funds, including ETFs and mutual funds that mimic indexes such as the S&P 500, must adhere to specific diversification requirements. These regulations ensure that no single issuer accounts for more than 25% of the total assets in the portfolio, and securities representing over 5% of total assets cannot exceed 50% of the portfolio.
For instance, the S&P sector indexes, which underpin widely-traded ETFs like the Technology Select SPDR ETF, have similar diversification rules. They stipulate that no single stock can exceed 24% of the float-adjusted market capitalization of the relevant sector index, and companies with weights over 4.8% cannot exceed 50% of the total index weight.
In the Technology Select Sector, three companies – Microsoft, Apple, and Broadcom – had weights greater than 4.8%. Their combined market weight was 51.2%, implying a possible reduction in Apple and Microsoft in the index.
Market concentration is not a recent phenomenon; concerns regarding this issue have persisted for decades. In the 1970s, for example, the weight of the five largest companies in the S&P 500 amounted to approximately 25%, similar to the current scenario.