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Nvidia (NVDA) hit its record 43rd close on Tuesday, bringing its 2024 return close to 175%.
Unfortunately, passive investors who rely on mutual funds and ETFs as investment vehicles have not been able to participate in all of these gains.
Micron (MU), Qualcomm (QCOM), KLA Corp (KLAC) and Lam Research (LRCX) also closed at all-time highs on Tuesday, catapulting the broader S&P 500 Tech Index to its own record and adding to its annual performance. -data return to an enviable 31%.
But the closest investment option – the Technology Select Sector SPDR Fund (XLK) – is underperforming its technology sector benchmark by more than 10 percentage points this year.
And the question arises from the success of the biggest names in technology.
The core of passive investing is premised on risk management through diversification. In theory, a diversified technology index is “safer” than one 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 up against rules and regulations that limit the weight of individual stocks in the funds.
In theory, each of these three giants should be weighted at just over 20% of the XLK fund – if it matched the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only represents 5.9% of the ETF.
This state of affairs will soon change – drastically. With this, however, another complication will arise: Apple’s weight will fall drastically.
After Friday’s close, the XLK ETF will rebalance to reduce Apple’s 22% holding to 4.5% and increase Nvidia’s 5.9% holding to 21.1%, based on Bloomberg estimates .
This all stems from the Great Depression era investor protection lawswhich requires indexes to limit the concentration of individual stocks to earn the “diversified” label.
Investors who enjoy reading prospectuses may enjoy the shaky legal jargon that explains the need for these changes, as expressed in this Common questions and corresponding index methodology published by S&P Dow Jones Indices.
In short, there are four companies – Nvidia, Apple, Microsoft and Broadcom – that pass the critical 4.8% threshold for individual names in a diversified index. And because they collectively exceed 50% of the entire index by weight, the weights of the smaller members are reduced according to a formula until all legal limits are respected.
In total, Friday’s rebalancing is expected to force the sale of $12.7 billion in Apple shares and the purchase of $11 billion in Nvidia shares.
That’s close to the dollar value of Apple shares trading on a given day and about a quarter of the dollar value that Nvidia trades on a daily basis. In other words, they are material values.
Fortunately for investors, these are highly liquid stocks and the investment community will have had a full week to digest the scenario when the rebalancing takes effect on Friday.
Of course, there are many companies no in the trillion-dollar club — and in the companies that aren’t exactly AI plays — that have rewarded investors handsomely this year.
Dow component Walmart (WMT) is up nearly 30%. GameStop (GME) is up 40%. And Abercrombie & Fitch (ANF) stock has returned an impressive 110% this year.
But rebalancing raises the issue of an overlooked risk to the passive investment strategy favored by the masses, which is that they may miss out when only a few names get lucky.
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