The ever-increasing size of a handful of mega-cap stocks has caused these names to have a dominant influence on the U.S. stock market, especially within major indices like the S&P 500 as well as sectors including Technology and Communication Services.
This dynamic has caused the U.S. stock market to become significantly concentrated. As of 2024, the S&P 500 Index concentration has hit record levels with the top 10 stocks accounting for 35.6% of total S&P 500 market cap as of August.
ETFs and mutual funds are required to meet certain diversification requirements to benefit from the tax advantage of registering as a regulated investment company (RIC). RICs are considered pass-through entities by the IRS, with taxes owed at the individual level, but not the fund level.
The diversification requirements include the following:
The overall significance of these requirements to ETF and mutual fund returns varies year-to-year depending on the index and sector. The record levels of market concentration being witnessed in 2024 are causing this dynamic to have an outsized impact on year-to-date (YTD) returns this year.
Included below are the top 10 stocks with the biggest differential in weighting between and the SPDR S&P 500 ETF Trust (SPY). Taking Alphabet (GOOGL) as an example, an investor purchasing shares of the passive SPDR Communication Services Select ETF (XLC) is only getting a 26.6% exposure to GOOGL relative to the S&P 500 Communication Services Index weight of 46.4%, constituting a 19.8% underweight to this single name. Amazon (AMZN) and NVDIA (NVDA) have similar dynamics with underweights of 13.4% and 12.8%, respectively.
Consider the fact that through October 15th, GOOGL has rallied 18.7% YTD, AMZN 23.5%, and NVDA a whopping 165.8%! That is a lot of returns passive investors are missing due to RIC regulations.
The table below provides a view of 2024 YTD sector ETF returns relative to S&P 500 Index sector returns.
As you can see, the differential in returns for highly concentrated sectors such as Technology and Communication Services is substantial. Looking at Technology through October 15th, the SPDR Technology Select Sector ETF (XLK) has seen 2024 YTD returns of 19.9% versus the S&P Information Technology Index YTD returns of 32.6%. That constitutes a 12.6% discrepancy, with investors in XLK missing that 12.6% return differential.
While passive ETFs for sectors and styles are great tools for investors during certain times they can underperform their benchmark. Working with an investment manager like VGA can help close the gap with active risk management and strategies that manage position size strategically.
Vineyard Global Advisors offers 13 fee-only, actively managed, including hedged and long-only investment strategies via separately managed accounts. Contact Us to learn more.
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