S&P 500 has a concentration problem: Why ETFs can't keep up

00:00:00 Speaker A

The S&P 500 has a concentration problem. The most important stock or index in the world is more top heavy than it has been in the last 45 years. The 10 biggest stocks, they make up nearly 40% of the index. What’s behind this mess? The rules for registered investment companies or Ricks were created way back in the 1930s and 1940s for mutual funds to make sure they didn’t get too concentrated in just a few stocks. But modern ETFs that only go back to the beginning of this century, they have to comply with them too. In particular, these so-called Rick rules, they say that no single stock can make up over a quarter or 25% of a fund. And the sum of all the stocks together making up at least 5%, they cannot exceed half of the fund or 50%. So it’s great for diversification, but in a mega cap world, it forces ETFs that are supposed to be passive to dial down the biggest names. Now look at this table of four S&P 500 sectors and their top three stocks. For instance, in communication services, we have Alphabet or Google with 38%, Meta with 31%, Netflix with 10%. Add them up and you get 79%. That is way too far too far over that 50% that’s required by the rule. And a similar thing happens with the tech sector with consumer discretionary. And this one surprised me. Even the energy sector, Exxon Mobile, Chevron and Conoco Phillips, they add up to 55%, just a little bit too high. But the bottom line is an ETF cannot just copy and paste that concentration and still pass the Rick test. They have to cut their biggest weights. Now here is the real world impact. In this chart right here, the performance of the S&P 500 tech sector in green, this is since the start of this bull market in October of 2022. That white line below it, that is a performance of the technology select spider fund, which we know by the ticker XLK. All you need to notice is that big gap between the two lines at the right side of the chart. XLK is up 126%, but the actual tech sector of the S&P 500, that’s up 158%. And that is a difference of 32 percentage point. That’s a big gap. Here’s the same story in a table that shows the gap in performance for all four of the sectors we’ve been discussing over this nearly three-year-old bull market. Tech has the biggest difference. We just took care of that. But communication services with alphabet and meta, that has a difference of 16 percentage points. Then you can see there’s only a small difference of three percentage points for consumer discretionary. That’s where you find Amazon and Tesla. And there’s virtually no difference for the small returns in the energy sector, which is more or less traded sideways through through this bull market. So here comes the fix. There are newer ETFs designed to get closer to the index concentration while remaining compliant with all the rules. This table here, it focuses exclusively on the tech sector and its three biggest weights. Those would be Nvidia, Microsoft, and Apple. We have the weights of each within the S&P 500, the weights within the new global X pure cap tech ETF with the ticker GXPT. And finally, at the bottom, we show the weights in XLK, which we’ve discussed, has been around most of this century. Note that the new GXPT ETF gets much closer to the weights in the S&P 500 for those three stocks. Now, finally, this table here shows the total weight of those three stocks, Nvidia, Microsoft, and Apple in each of the same three instruments from the last table. S&P 500 tech sector, GXPT, and XLK. Now the new GXPT at 60%, it gets pretty close to the S&P 500 tech sector at 62%, while XLK is stuck down at 42%. Now, there is a trade-off to getting around all these concentration rules, and it comes down to fees. GXPT charges a management fee of a quarter of 1% per year, while XLK, it’s only 0.03%. That’s 1/8 of the new tech ETF. So you’re paying more to get closer to that concentrated index profile. I should also add that the select spider funds like XLK and XLY, they aren’t doing anything wrong. They’re just following the rules that they’ve been in place for decades. So the bottom line is, in today’s market, it’s built around a handful of colossal winners and concentration, it may ease or it may stick around, but at least now you can choose how closely you want to ride with the giants. Tune into stocks and translation podcast for more jargon busting deep dives. New episodes can be found Tuesdays and Thursdays on Yahoo Finance’s website, or wherever you find your podcast.