Is Your Portfolio Keeping Up with the Indices? You May Need to Diversify.

Did you see the data in Dave’s recent post about the overconcentration of Tech stocks in the S&P 500 and think it was surprising? If so, I have some news for you…

The Nasdaq 100, a subset of the Nasdaq Composite Index that is frequently referenced in financial media, is undergoing a special rebalance on July 24th. Since its launch in 1985, this has only happened two other times in its almost 40-year history. What’s triggering this special rebalance? The Nasdaq 100 index, often used to represent U.S. Growth stocks, has become too concentrated and needs to diversify its allocation.

2023: Year of the “Magnificent Seven”

The Nasdaq 100 is made up of the one hundred largest non-financial companies listed on the Nasdaq exchange. As of 7/11/2023, seven companies make up more than 54% of its allocation: Microsoft (ticker: MSFT), Apple (ticker: AAPL), Amazon (ticker: AMZN), Google parent Alphabet (tickers: GOOG & GOOGL), Tesla (ticker: TSLA), Nvidia (ticker: NVDA) and Meta (ticker: META) formerly known as Facebook.

These stocks are being anointed the “Magnificent Seven.” Previously, there were the “FAANG” stocks, then it was adjusted and renamed to the “MAMAA” stocks and now—the “Magnificent Seven.”

Hokey labeling conventions aside, I think many people would agree these have been and remain some of the most influential companies across the globe. They are behemoths that touch so many aspects of the economic world and our daily lives. They’ve also had an outsized influence when it comes to index level investment returns, especially in 2023. Look at the difference between these two ETFs in the chart below: one is the standard, cap-weighted Nasdaq 100 represented by $QQQ and the other is the equal-weighted Nasdaq 100 represented by $QQQE.

As of July 11th, $QQQ has outperformed $QQQE by +16% so far this year. All thanks to being heavily allocated to the “Magnificent Seven” stocks.

The Nasdaq 100 is essentially a cap-weighted index meaning the largest market-cap stocks get the highest allocations and have the most impact on the index’s performance. The Equal Weighted Nasdaq 100 which, as the name implies, gives every position an equal allocation. Equal Weight indices usually offer a better view into how the “average” stock in the index is performing.

The mega-cap Tech stocks have posted unbelievably high returns and are drastically outperforming the average stock within the index. Thanks to its cap-weighting methodology, the allocations to the “Magnificent Seven” stocks have ballooned to concerning levels within the index. In fact, their allocations inside the index have grown so much that the index providers are conducting a special one-time rebalance on the heels of its recent standard quarterly rebalance.

Too Much of a Good Thing Can Be a Bad Thing

While outperformance is never an issue, being overconcentrated in a handful of holdings is.

Clearly the people running the index respect this risk and so does the SEC. The SEC has specific diversification rules that registered investment companies, which includes publicly traded index ETFs, must follow. Since one of the goals of buying a passive index ETF is to gain diversified exposure to broad markets through owning a single investment product, the SEC has limits on the aggregate weights of the largest stock holdings for those products.

To help prevent these index-tracking products from violating SEC regulations, the providers of the Nasdaq 100 have their own diversification rules. The index methodology sets out limits that should come into play before the SEC limits. Per its methodology, the combined total of positions that have at least a 4.50% individual weight inside the index, cannot be greater than 48% of the total index’s allocation. At about 54%, the index has hit this limit and now the index providers are taking action.

Let that sink in. A “passive” index is making an “active” decision to reduce risk and its exposure to the best-performing positions by increasing its diversification. That’s not something you see every day.

Be Grateful for Diversification…and Eat Your Free Lunch

Most investors reading this right now probably have some exposure to these mega-cap Tech names, either by owning an ETF like $QQQ or by holding the individual stocks of the “Magnificent Seven.”

First off, if you own these, congratulations! You most likely have some strong portfolio gains thanks to recent market action. Those gains are likely even higher if you’ve held these positions for years. However, if that’s the case it’s probably time to review your allocation.

If you own the $QQQ, your ETF will rebalance automatically since the underlying index itself is making changes. But if you own the individual stocks, there’s a chance you could be seriously overallocated to the stocks that have been on a rocket ship to higher levels. While those holdings may have helped your recent performance, maybe now is the time to diversify. 

I’m not saying you have to or even should make changes to your allocation—that decision depends on the specific circumstances of your financial plan. But even the Nasdaq 100, a passive index, is taking an active approach to risk management, so why wouldn’t you at least consider taking some similar actions to boost your diversification and reduce your overall risk profile?

Diversification is key to managing risk and adds protection to your portfolio. True diversification means there should be at least one investment or strategy in your portfolio that’s underperforming at all times. That might seem counterintuitive, but think about it: if everything you own is going up rapidly, what’s stopping it from all going down just as quickly? Short answer: probably nothing.  

If you are DIY-ing your portfolio, or your current advisor is overexposing you to concentration risk (I.e., by being heavily overweight to Tech stocks), maybe it’s time for a second opinion. A responsible Wealth Manager understands the importance of diversification.  They shouldn’t be so focused on the possibilities of outsized portfolio returns that they ignore the risks to your long-term financial plan that come with an overconcentrated allocation.

Nobel Prize winner Harry Markowitz reportedly said that “diversification is the only free lunch” in investing. I’ve rarely turned down a free lunch in my life, especially when it comes to investing. And I hope you won’t either!

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