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Nvidia (NVDA) hit its 43rd record closing high on Tuesday, putting its 2024 return close to 175%.
Unfortunately, passive investors who rely on mutual funds and ETFs as investment vehicles have not been able to share in all of these gains.
Micron (MU), Qualcomm (QCOM), KLA Corp (KLAC), and Lam Research (LRCX) also closed at all-time highs on Tuesday, pushing the broader S&P 500 to its own record and moving its index higher since the beginning of the year. -History of returning to an enviable 31%.
But the closest investable match — the Technology Sector SPDR Fund (XLK) — has underperformed the technology sector index by more than 10 percentage points this year.
The problem arises from the success achieved by the biggest tech names.
The essence of passive investing is based on managing risk through diversification. In theory, a diversified technology index is “safer” than one in which three stocks dominate the index.
But over the past four years, Apple (AAPL), Microsoft (MSFT), and Nvidia have so completely outpaced the rest of the market that ETFs are running afoul of rules and regulations that limit the weighting of individual stocks in the funds.
In theory, each of these three giants should be weighted at just over 20% of the XLK fund – if it matches the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only makes up 5.9% of ETFs.
This situation will soon change – radically. However, another problem will arise: Apple's weight will decline sharply.
After Friday's close, the XLK ETF will be rebalanced to reduce Apple's 22% stake to 4.5% and increase Nvidia's 5.9% stake to 21.1%, based on Bloomberg estimates.
This all stems from the Great Depression era Investor protection lawswhich requires indices to limit the concentration of individual stocks to obtain a “diversified” designation.
Investors who are keen to read prospectuses may enjoy the shaky legal text explaining the need for these changes as expressed herein Instructions And the interview Index methodology Published by Standard & Poor's Dow Jones Indices.
In sum, four companies — Nvidia, Apple, Microsoft, and Broadcom — exceed the critical threshold of 4.8% for individual names in a diversified index. Because they collectively exceed 50% of the total index by weight, the weights of the smallest members are reduced according to a formula until all legal limits are respected.
Finally, Friday's rebalancing should result in a $12.7 billion sale of Apple stock and an $11 billion purchase of Nvidia.
That's close to the dollar amount Apple stock trades on any given day, and about a quarter of the dollar amount Nvidia trades daily. In other words, these are material amounts.
Fortunately for investors, these stocks are highly liquid, and the investment community will have a full week to digest the scenario by the time the rebalancing takes effect on Friday.
Of course, there are a lot of companies no In the trillion-dollar club — and companies that aren't exactly playing AI — have rewarded investors handsomely this year.
The Dow Jones component Walmart (WMT) is up nearly 30%. GameStop (GME) price rose 40%. Abercrombie & Fitch (ANF) stock has returned a whopping 110% this year.
But the rebalancing raises the issue of an overlooked risk with the crowd-favorite passive investing strategy, which is that it may miss out when there are only a few names holding a lot.
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