The Changing Landscape of Tech Companies: S&P Dow Jones Revamps Rules Amidst Rising Concentration

The recent surge in tech giants' valuations has prompted a rulebook revision by S&P Dow Jones Indices, highlighting the evolving market landscape and potential risks for passive investors.

The investment landscape has witnessed a profound transformation in recent years, with a handful of tech behemoths eclipsing the rest. The valuations of Apple, Microsoft, and Nvidia, the three largest U.S. companies by market value, have soared past $3 trillion this year, dominating the S&P 500's information-technology sector.

This concentration of market power has posed challenges for index-tracking funds, which aim to mimic the performance of specific market segments. The SPDR Technology Sector ETF, one of the world's largest exchange-traded funds, faced a disparity in its exposure to the three tech giants. Despite their comparable market values, Nvidia's weight in the fund was four times that of Apple, leading to underperformance for shareholders.

The Changing Landscape of Tech Companies: S&P Dow Jones Revamps Rules Amidst Rising Concentration

Under federal securities rules, mutual funds and ETFs cannot invest more than 25% of their assets in a single stock, and the combined weight of companies exceeding 5% of the fund's assets cannot exceed 50%. To comply with this 50% rule, S&P Dow Jones Indices has traditionally capped the weight of the smallest constituent with a greater than 5% weight until the index falls below the concentration threshold.

However, the unprecedented rise of Nvidia challenged this approach. In early June, Nvidia briefly surpassed Apple's market capitalization, causing its weight in the SPDR fund to jump to 21%, while Apple's was reduced to 4.5%. This prompted index-tracking funds to sell tens of billions of dollars in Apple shares and buy Nvidia stock in its place.

The Changing Landscape of Tech Companies: S&P Dow Jones Revamps Rules Amidst Rising Concentration

Recognizing the growing discontent among investors and the need to address the concentration issue, S&P Dow Jones Indices revised its methodology to comply with the rules. Ahead of its September rebalance, the index provider lowered the weights of Apple, Microsoft, and Nvidia proportional to their market capitalization, ensuring that they collectively comprised less than 50% of the SPDR fund.

Without these changes, the fund would have once again been forced to engage in a massive swap between Nvidia and Apple shares, as Apple regained its position as the largest U.S. company.

The Changing Landscape of Tech Companies: S&P Dow Jones Revamps Rules Amidst Rising Concentration

Concentration issues are particularly pronounced in sector indexes that offer focused exposure to specific industries. In July 2023, the tech-heavy Nasdaq-100 Index underwent an unscheduled special rebalance to prevent its biggest companies from exceeding 50% of the benchmark.

These rulebook revisions underscore the evolving market landscape and the challenges posed by the growing dominance of tech giants. Passive investors, who often rely on index-tracking funds to diversify their portfolios and minimize risk, should be aware of the potential implications of these changes.

While passive investing has historically offered strong returns, the rise of a select few tech companies has introduced new dynamics that investors need to consider. The concentration of market power in the hands of a few players can lead to underperformance if those companies falter or if their valuations become overextended.

As the tech sector continues to evolve, it remains to be seen how these rulebook revisions will impact investors and the broader market landscape.