Rise of the tech giants exposes the problem of index distortions
The writer is an adviser to fintech companies and a former financials research analyst
Mega market cap stocks are eating their indices, distorting their usefulness in some cases as market gauges for investors.
The most widely used index in the world is the S&P 500, which is supposed to be a broad barometer of the US stock market but has increasingly been driven by a small number of tech giants. This year, the S&P 500 is up by about 10 per cent but with much of its returns 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 per cent of the market capitalisation of the S&P 500 and 60 per cent of the Nasdaq 100. JPMorgan analysts last month said the US equity rally was driven by the narrowest leadership in a rising stock market since the 1990s.
As market tides come and go, there will always be periods when stocks or sectors dominate market indices. But the degree of imbalances now adds to the onus on investors, when choosing a passive investment vehicle, to check whether it actually provides diversification or exposure to the sector they are hoping 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 definitely not reflective of the health of the overall US stock market.
In more focused or sector-specific indices, the issues are starker. The ETF sector is highly liquid and transparent. Most major indices still work well mechanically. But for all the calls for index providers to ensure objectivity and rigour, industry classifications are always going to be somewhat subjective. Including or excluding a small group of the largest stocks can skew these indices significantly.
Take the recent shift of payments processors including Visa and Mastercard out of the S&P’s technology sector and into the financials sector. In many banking crises of the past, the Financial Select Sector SPDR Fund, or XLF ETF, has been a proxy way to gain or hedge exposure to the US banking sector as it tracked the S&P financials index.
During the recent banking crisis, the KBW US banks index was often referenced more publicly as a benchmark, but the XLF remains the largest and most liquid route to play the financial sector.
Yet today, a little under 30 per cent of this index is composed of Apple shareholder Berkshire Hathaway, Visa and Mastercard. The inclusion of a slew of data vendors, exchanges and fintechs means that banks are now a smaller proportion of this sector 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. Following recent share prices moves, Apple and Microsoft now account for about 47 per cent of the market capitalisation of the Technology Select Sector SPDR Fund, or XLK, which tracks the S&P index. This means the benchmark is hitting concentration limits allowed by US regulation, illustrating the challenges of index composition.
Even apart from concentration issues, there are questions about how representative the S&P technology sector index is of Big Tech stocks. Several years ago, the likes of Meta — then Facebook — and Alphabet were reclassified as communications companies.
Despite the huge value in its web services and cloud computing arm, Amazon is considered a consumer discretionary stock by S&P. The increasing tendency of companies to be technology-enabled is blurring the lines between the sectors they could belong to.
One of the fastest-growing areas for indices has been thematic investing and, in particular, strategies focused on environmental, social and governance factors. Under the threat of regulatory scrutiny, index providers are tightening disclosures, inclusion criteria and ratings. Nevertheless, 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 generally, such differences and index imbalances of course provide opportunities for active fund managers to prove the case for their role — to bet against a market benchmark, say, to wager that the dominance of the likes of Microsoft or Apple might not last. For passive investors, they should serve as a reminder that indices are still flawed, human-made constructs with sometimes arbitrary classifications. We still need to do our homework when choosing them.