Nasdaq Rebalance Spotlights Risks from Supersized Set of Stocks

Even benchmark-makers are starting to address the supersized influence of heavyweight stocks. Nasdaq’s plan to reconfigure the weights of its constituents should prompt investors to think about the broader concentration risks in US equity markets, particularly in passive portfolios.

Nasdaq’s decision to carry out a “special rebalance” of its leading technology-strong index is a sign of the times. Excitement over artificial intelligence (AI) has fueled exceptional gains for its seven largest constituents which accounted for about 55% of the Nasdaq 100 as of June 30. On July 24, the US exchange operator will rejig the composition of the index to reduce the aggregate weight of these seven stocks.

Big 10 US Stocks Dwarf Several Overseas Markets

Concentration risks extend beyond Nasdaq. The broader S&P 500, too, is heavily tilted toward the largest names, mostly from technology and e-commerce industries. The 10 largest weights accounted for 32% of the S&P 500 at the end of June, with a combined market capitalization of $12.2 trillion. That dwarfs the value of leading benchmarks in Germany, China, the UK and Japan (Display).

Valuations of the US mega-caps have skyrocketed. The median price/forward earnings ratio of the big 10 surged by 48% to 28.2x at the end of June, compared to the median increase of just 7% for the rest of the market. Valuations of the top 10 were driven by multiple expansion, as the median forward earnings-per-share (EPS) forecast increased by only 0.2%; for the rest of the market, the median EPS forecast slipped by 0.4%. This suggests that across the broader market, investors can find stocks with relatively attractive valuations for their earnings power.

Finding Growth Beneath the Giants

Some of the tech titans are good investments. But we believe that each stock should be evaluated based on its business fundamentals, earnings outlook and valuation, and positioned in a portfolio in line with its underlying investment strategy. Passive portfolios that hold all the mega-cap stocks at large benchmark weights will be vulnerable to a potentially painful reversal of sentiment.

Active portfolios can search for a wider array of companies that are suited to today’s complex conditions. Investors with a long-term horizon should resist the temptation to indiscriminately pile into the largest stocks and ensure that their portfolios offer diverse sources of growth potential—at the right price.