Big tech dominance is forcing index superpowers to rethink rules

The big tech boom is causing headaches for all-powerful index providers on Wall Street, who can send billions of benchmark-tracking dollars on the move with just a stroke of the pen.

Two of the world's biggest – FTSE Russell and S&P Dow Jones Indices – are presenting plans to undercut the weighting of the largest megacap companies in key indexes. The rare intervention comes as the US equity market becomes increasingly lopsided thanks to the growing dominance of the likes of Nvidia and Apple. 

Players of all stripes are being forced to adapt as the ownership of the largest tech shares in many portfolios starts to push against regulatory limits. And the pressure is building for the two index overlords, whose products are tracked by a combined $35 trillion.

The proposals offer fresh ammunition for critics of the passive-investing boom, who have long pointed out such strategies are more active than they appear. Any adjustments in an index reveal the hidden human hands behind the benchmarks.

"Most investors may not realize that there is some degree of activeness even in what we consider passive strategies," said Antti Petajisto, head of equities at Brooklyn Investment Group.

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Russell's consultation, which is about capping the weighting of the largest members of its widely followed US growth and value gauges, is open until Aug. 30, with no time frame set for implementation.

S&P's consultation — focused on a new approach to restrain companies in a family of sector measures — ends Friday, with the changes scheduled to take effect on Sept. 23 if they are adopted. 

Behind the proposals are longstanding rules for regulated investment companies that limit any single security to 25% of a portfolio and the aggregate weight of the largest holdings — those with a 5% representation or greater — to 50%. In the industry it's often dubbed 25/5/50.

Established to safeguard investors from over-exposure to too few names, the restrictions can be punishing in the modern market where companies such as Apple and Nvidia keep getting bigger.

Last month, the top 10 constituents of the Russell 1000 Index — which are mainly tech stocks — comprised 34% of the gauge. While that's not yet testing 25/5/50, it's a level of concentration unseen in the benchmark's 45-year history.

Russell already offers a suite of capped indexes to supplement its more traditional, unconstrained measures. What's being considered now is whether to apply weight caps to its standard style gauges, according to Catherine Yoshimoto, director of product management at FTSE Russell, an LSEG business. More than $7 trillion of assets are benchmarked to the firm's style indexes.

"Some clients are really pushing us to consider capping the standard Russell 1000 Growth Index, for example," she said. 

A spokesperson for S&P declined to comment beyond the consultation paper and its index methodology.

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Passive funds have been grabbing market share from their active rivals in the past two decades, thanks to rock-bottom costs and the perceived shortcomings of discretionary stock pickers. Still, some market participants like to point out that this index revolution is less radical than it appears.

In this view, top-down decisions are made by humans in virtually every stage of a "passive" strategy, whether it's writing the rules of an index, deciding how to apply them, designing the fund that tracks the benchmark, or actually executing its trades. For instance, contrary to what many assume, the S&P 500 Index — the main benchmark for the world's largest stock market — does not simply contain America's 500 biggest companies. Its members are selected by a group of anonymous index experts.

The proposed changes by S&P and Russell underscore the kinds of interventions that take place — and the differences between firms that can arise as a result.

When it comes to adhering to the 25/5/50 limits, index managers use differing mechanisms to cap a company's weight, as well as different triggers for when that process kicks in (although they all typically opt for a level slightly below 25/5/50 to provide a buffer.) 

For example, in its proposal, Russell presents a capping threshold at 20/4.5/48. That's different from the Nasdaq 100, whose methodology calls for 24/4.5/48, and S&P, whose cutoff is 24/4.8/50. The disparity likely reflects diverse approaches to determine the best way to reduce the probability of a breach occurring on a regular basis, according to Yoshimoto at Russell.

Meanwhile to cap company weights, indexes such as the Nasdaq 100 tend to trim top holdings proportionally. But when a number of stocks breach the limit in S&P's sector gauges, the smallest is trimmed first, suppressing its weight in the gauge — and leaving investors under-exposed. 

That's what happened in funds like the Technology Select Sector SPDR Fund in the first half of this year, when Nvidia was surging higher. The rules meant the fund under-owned the stock, so it trailed an uncapped tech benchmark by 10 percentage points in the period — the worst underperformance on record.

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Then, when Nvidia eclipsed Apple in June, it sparked a rebalance in which the fund bought an estimated $11 billion shares of the chipmaker at the expense of the iPhone manufacturer. Now that their positions are flipped again, the fund is at risk of another round of big shuffling. Should the current rankings hold until the next quarterly rebalance due September, Nvidia's weight in the fund may have to drop to 4.5% from 21% as Apple's spikes to 22% from 4.8%, based on the existing methodology.

S&P's proposed revision is aimed at reducing such frequent high turnovers, according to Edward Yoon, an index specialist at Macquarie Capital. Rather than targeting the smallest of the group that violates the diversification rule, the index owner proffers curbing them all in proportion to their market values. 

To Josh Kutin, head of asset allocation, North America at Columbia Threadneedle Investments, whatever emerges from the consultations is surely no bad thing as it will help investors tackle the challenge of the increasingly concentrated market.

"Asset allocators are obsessed with getting diversification so the more concentrated our portfolios are in any sense, the more uncomfortable we get," he said. "I'm in favor of changes to reduce the reliance on market cap in index construction, even if that's a human decision rather than a market mechanism."