With equity markets increasingly top-heavy in the age of big tech, S&P will now reduce the weighting of market leaders in proportion to their capitalization — if they breach size-related thresholds in even larger and key industry benchmarks, it said in a statement this week.
It is a physical departure from the current approach where the smallest of the group are first cut off their weight when a preset threshold is triggered.
The point is that the risk of concentration is increasing this year. Investment managers are scrambling to ensure their exposure to a handful of booming technology companies doesn’t touch decades-old regulatory limits. But the new rules will have a wider impact – the benchmark provider introduces a new capping initiative in its sector index that tracks everything from consumer staples to energy and communications.
The incoming rule, adopted after a month-long consultation with market participants, means passive investment vehicles like the Technology Select Sector SPDR Fund will need to shuffle their holdings accordingly in their next quarterly rebalancing.
When the change in S&P’s capping method goes into effect at the market close on September 20, Piper Sandler & Co. About $31 billion in trades will be initiated on major ETFs, about half of which will come from technology.
The improvement is welcome news for the fund industry, according to Michael Kantrowitz, chief investment strategist at Piper. Investment funds are sometimes called Nvidia Corporation and Apple Inc. because of the old way of holding back the behemoths. have been less exposed to major names like – and fueled volatile share turnover earlier this year.
It appears to be an attempt to increase the weight distribution more evenly in the construction of indices by “reducing unnecessary turnover,” Kantrowitz said. “This should alleviate some of the issues that caused the large tracking error,” he added, referring to the performance gap between the capped sector index and its uncapped version.
The move is the latest among a host of index providers to adapt to a concentrated equity market pushing against regulatory limits. Similar restrictions last year prompted the Nasdaq 100’s watchdog to carry out special rebalancing to keep index-tracking funds in compliance. Last month, FTSE Russell held a consultation on capping the weightings of the largest members of its widely followed US growth and value gauge.
Causing headaches for these index overlords are longstanding diversification standards for regulated investment firms that limit any single security to 25% of a portfolio and the aggregate weighting of the largest holdings — with 5% or more representation — to 50%. Established to protect investors from overexposure to too few names, 25/5/50 restrictions can be punishing in a modern market where companies like Nvidia and Apple continue to grow.
S&P’s capping trigger levels, which are slightly below the 25/5/50 limit to provide a buffer, have remained at 24/4.8/50 this time around. Research is involved in how the capping process is conducted.
Right now, three stocks each account for at least 4.8% of the uncapped tech gauge: Apple at 23%, Microsoft Corp. at 22% and Nvidia at 19%. With the total exceeding 60%, their weight will be reduced in proportion to their size to meet the 50% limit at the next rebalancing. The excess weight will then be distributed to other components of the index with a cap at 4.5%.
The old method would have required the smallest of the top stocks to cap first, and in that case, Nvidia would have been cut by up to 4.5%.
That’s what happened to XLK in the first half of this year, when Nvidia was surging. As a result, the fund underperformed the uncapped tech benchmark by 10 percentage points over the period – the worst underperformance on record.
Then, when Nvidia acquired Apple in June, it sparked a rebalancing in which XLK bought an estimated $11 billion of the chipmaker’s shares at the iPhone maker’s expense. Since then, as Apple has outperformed, the fund’s investors have lost some gains.
Under S&P’s new rules, however, XLK is set to avoid another round of major swaps like June, as Nvidia falls behind Apple in market value.
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