Concentrated Indices: Are They Distorting the US Stock Market?
With the proliferation of exchange-traded funds (ETFs), investors now have more ways than ever to access the stock market. ETFs have become vastly popular due to their low fees, portfolio diversification, and liquidity. Despite all their benefits, however, investors using passive investment vehicles like ETFs run the risk of becoming overly exposed to a small group of large companies. This phenomenon occurs when massive corporations with outsized market capitalizations dominate the stock market.
One way this trend appears is through the indices that ETFs attempt to track. In particular, the two most popular indices—S&P 500 and Nasdaq 100—are particularly vulnerable to the trend of corporations with large market caps dominating the market. Unfortunately, this can create a situation where the index becomes less useful for passive investors, as its ability to reflect the sentiment of the overall market is compromised.
Beyond problems with indices being less representative of the overall market, there are more significant issues related to the composition of indices. Objectivity and rigor are key factors used to evaluate the legitimacy of index providers. However, industry classifications and subjective value judgments can remain a significant problem.
The reclassification of Visa and Mastercard is a perfect example of how the arbitrariness of index composition can be a problem. In the past, payment processors like Visa and Mastercard were part of S&P’s technology sector and were classified as technology companies. Still, recently they have been moved to a financial sector. This reclassification results in a distorted financial index which treats nearly 30% of the entire index made up of Apple shareholder Berkshire Hathaway, Visa, and Mastercard.
Moreover, such stock market concentration issues carry heavily weighted repercussions in specialized and focused indices. ETF players gained significance in recent years, with most major indexes mechanically well-functioning. The Index industry also permeates transparency and liquidity, but at the same time, the level of concentration in the market increases the burden on investors. They must verify whether the ETFs they buy indeed provide the sector exposure and diversification they desire.
### Thematic Investing is on the Rise
One bright spot in the world of investing lies in thematic investing, particularly those strategies focusing on environmental, social, and governance (ESG) factors. At the moment, despite being riddled with less-than-perfect data, regulatory scrutiny, inclusion criteria, and ratings, the trend of thematic investing is on the rise. As this momentum continues, more index providers tighten their grips on the inclusion criteria and directives. The adoption of ESG in investing steers the tide of capitalism towards more social, environmental, and governance sustainability.
### The Future of ETFs
As a reminder to passive investors, indices remain a man-made construct and still bear imperfections, whether dealing in more focused or sectoral indices. Regardless, ETFs can be an efficient way for investors to gain broad market exposure. That said, it’s in passive investing’s best interests to research the ETF offerings before making any investment decisions.
Stakeholders can anticipate the future of ETF investing to be heavily impacted by the growth of ESG and the creation of sustainable investment vehicles. This offers yet another reason for investors to do their homework before factoring in the new emphasis on ESG factors. By doing so, investors stand the greatest chances of aligning their passive investment strategies with their individual investment styles, objectives, and priorities.
## Summary
Concentrated indices have become a problem for investors accessing the stock market via ETFs. The problem with relying on indices too heavily is that passive investors can get exposed to dominant players in the stock market, rendering their holdings insufficiently diversified. In addition to these problems, errors made in index compositions, like the Visa and Mastercard reclassification, can further compromise the quality of the financial index. Thematic investing is on the rise, particularly in the area of sustainable investing. As such, there is a growing need to do research on ETF offerings before embarking on any investments to maximize investment returns.
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The author is a fintech company advisor and former financial research analyst
Stocks with mega market caps are eating into their indexes, skewing their usefulness in some cases as market indicators for investors.
The most used index in the world is the S&P 500, which should be a broad barometer of the US stock market, but has increasingly been led by a small number of tech giants. The S&P 500 is up about 10% this year, but most of its returns have been driven by Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta and Tesla.
A similar trend can be seen in the Nasdaq 100. These seven stocks now account for about 29% of the market capitalization of the S&P 500 and 60% of the Nasdaq 100. JPMorgan analysts last month said the rally in US equities is been led by the narrowest leadership in a growing stock market since the 1990s.
As market tides come and go, there will always be times when stocks or sectors dominate market indexes. But the degree of imbalance now increases the burden on investors, when they choose a passive investment vehicle, to verify whether it actually provides the diversification or sector exposure they hope for.
For example, the five largest exchange-traded funds by assets under management include three S&P 500 trackers from BlackRock, Vanguard and State Street, while the dominant ETF for the Nasdaq 100 is Invesco’s QQQ. Such increasingly concentrated indices are by no means a reflection of the health of the US stock market overall.
In more focused or sectoral indices, the problems are more evident. The ETF industry is highly liquid and transparent. Most of the major indexes still work fine mechanically. But despite all the demands placed on index providers for objectivity and rigour, industry classifications will always be somewhat subjective. The inclusion or exclusion of a small group of the largest stocks can significantly distort these ratios.
Take the recent shift of payment processors, including Visa and Mastercard, out of S&P’s technology sector and into the financial sector. In many past banking crises, the Financial Select Sector SPDR Fund, or XLF ETF, has been a way to procure or hedge exposure to the US banking sector while tracking the S&P financial index.
During the recent banking crisis, the KBW US Bank Index was often cited more publicly as a benchmark, but the XLF remains the broadest and most liquid avenue to play in the financial sector.
Yet today just under 30% of this index is made up of Apple shareholder Berkshire Hathaway, Visa and Mastercard. The inclusion of a slew of data providers, exchanges and fintechs means that banks are now a smaller percentage of this industry index, and even Citigroup is no longer a top 10 constituent.
And the reclassification of Visa and Mastercard as financials leaves behind an unbalanced S&P technology index. As a result of recent stock price movements, Apple and Microsoft now account for approximately 47% of the market capitalization of the Technology Select Sector SPDR Fund, or XLK, which tracks the S&P index. This means that the benchmark is reaching the concentration limits allowed by US regulation, illustrating the challenges of index composition.
Even concentration issues aside, there are questions about how representative the S&P Technology Sector Index of Big Tech stocks is. Several years ago, the likes of Meta – then Facebook – and Alphabet were reclassified as communications companies.
Despite the huge value of its web services and cloud computing arm, Amazon is considered a consumer discretionary stock by S&P. The growing trend of companies to be tech-enabled is blurring the lines between which industries they might belong to.
One of the fastest growing areas for the indices has been thematic investing and, in particular, strategies focusing on environmental, social and governance factors. Under threat of regulatory scrutiny, index providers are tightening disclosures, inclusion criteria and ratings. However, in an area where we are dealing with less than perfect information, there will always be a huge number of value judgments and differences between index providers.
More broadly, such index differences and imbalances obviously offer opportunities for active fund managers to demonstrate their role: betting against a market benchmark, for example, to bet that the dominance of companies like Microsoft or Apple may not last. For passive investors, they should serve as a reminder that indices are still imperfect, man-made constructs with sometimes arbitrary classifications. We still have to do our homework when choosing them.
https://www.ft.com/content/e0176208-fa3e-453c-8a9d-0bca61af9cdf
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