Admittedly, these three companies are special.
Nvidia is the OG poster child for the AI age, while there’s much more to Microsoft and Apple than Excel spreadsheets and iPhones.
They represent entire ecosystems in their own right.
It’s still an astounding statistic though, that three companies rival entire sectors of industries that employ millions, generate steady profits and have long been seen as portfolio ballast.
Over the past 25 years those four sectors have represented (on average) about one-third of the market, while back in 2009 they were approaching 50%.
That was in the depths of the GFC, when these sorts of companies proved much more resilient than the rest of the US market.
This market concentration has been steadily building over the years, but this recent stretch has been dramatic and today these three essentially define the market’s performance.
Fantastic stuff if you’re on the right side of it and by default, investors in passive ETFs or funds largely have been.
However, it also raises a few awkward questions.
What does a broad exposure to the world’s biggest economy and sharemarket mean if the bulk of returns come down to a couple of tech giants?
How do we remain diversified when one stock can outweigh entire sectors that were once considered the definition of stability and safety?
There’s another wrinkle, as many US funds and ETFs operate under long-standing diversification and tax rules, which were designed to stop portfolios becoming overloaded in one or two names.
When an index becomes too concentrated, those funds can’t track it exactly.
That’s why sector ETFs often cap the size of their biggest holdings, or use slightly modified versions of the benchmark.
The issue has become so pronounced that even the index providers themselves have been forced to act.
FTSE Russell, one of the most influential benchmark creators, recently changed some rules that had been in place for decades to stop a handful of stocks overwhelming its flagship indices.
The Investment Company Act of 1940 and the regulated investment company (RIC) tax rules have governed US funds for more than 80 years, but these were designed for a much broader and more balanced market than we see today.
The market has become so top-heavy that the scorekeepers have had to fine-tune and rewrite the rules of the game.
This isn’t unique to America, and in fact the issue is even more pronounced here in New Zealand.
Our three biggest companies – Fisher & Paykel Healthcare, Auckland Airport and Infratil – make up a staggering 35% of the NZX 50 index.
If you buy a passive fund that follows our benchmark index, you’re increasingly betting on those three companies doing well.
There’s no question these are all excellent businesses, but I’m not sure I want to be quite that concentrated, either here or abroad.
Nobody can deny the innovation coming out of today’s technology sector, or the enormous gains it’s delivered to investors.
Nvidia and friends have earned their place at the top, but the sheer size of this group means the market is much less balanced than the labels suggest.
Investors following these indices should be mindful of just how much is riding on a small group of companies.
Mark Lister is Investment Director at Craigs Investment Partners. The information in this article is provided for information only, is intended to be general in nature, and does not take into account your financial situation, objectives, goals, or risk tolerance. Before making any investment decision Craigs Investment Partners recommends you contact an investment adviser.
