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Nvidia (NVDA) recorded its 43rd record on Tuesday, bringing its return for 2024 to almost 175%.
Unfortunately, passive investors who rely on mutual funds and ETFs as an investment vehicle have not been able to take advantage of all these gains.
Micron (MU), Qualcomm (QCOM), KLA Corp (KLAC) and Lam Research (LRCX) also closed at record highs on Tuesday, catapulting the broader S&P 500 Tech Index to its own record and raising its year-to-date record. -date return to an enviable 31%.
But the closest investable partner – the Technology Select Sector SPDR Fund (XLK) – is underperforming its technology sector benchmark by more than 10 percentage points this year.
And the problem stems from the success of the biggest tech names.
The core of passive investing is based on managing risk through diversification. In theory, a diversified technology index is ‘safer’ than an index 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 running afoul of rules and regulations that limit the weight of individual stocks in funds.
In theory, each of these three giants should weigh just over 20% of the XLK fund – if it matches the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only comprises 5.9% of the ETF.
This state of affairs will soon change drastically. However, this will create another complication: Apple’s weight will fall sharply.
After the close Friday, the XLK ETF will rebalance to reduce Apple’s 22% share to 4.5% and increase Nvidia’s 5.9% share to 21.1%, based on Bloomberg estimates .
All of this stems from Great Depression-era investor protection laws, which require indexes to limit the concentration of individual stocks to earn the “diversified” label.
Investors who enjoy reading prospectuses may enjoy the shaky legal language explaining the need for these changes, as expressed in this FAQ and the associated 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 together they exceed 50% of the entire index in weight, the weights of the smallest members are reduced according to a formula until all legal thresholds are met.
All told, Friday’s rebalancing should require selling $12.7 billion of Apple shares and $11 billion of Nvidia.
That’s close to the dollar amount of Apple stock traded on a given day, and about a quarter of the dollar amount Nvidia trades daily. In other words: it concerns material amounts.
Fortunately for investors, these are highly liquid stocks, and by the time the rebalancing takes effect on Friday, the investing community will have had a full week to digest the scenario.
Of course there are plenty of companies not in the trillion-dollar club — and companies that aren’t exactly AI players — that have rewarded investors handsomely this year.
Dow component Walmart (WMT) is up almost 30%. GameStop (GME) is up 40%. And shares of Abercrombie & Fitch (ANF) have returned a whopping 110% this year.
But rebalancing does raise the issue of an overlooked risk to the passive investment strategy favored by the masses, namely that they might miss out if only a few names are in control.
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