Bubble fears siphon ETF flows away from Magnificent Seven (2024)

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Investors are pushing back against the dominance of the “Magnificent Seven” by increasingly looking for alternatives that downplay the power of the US tech elite as concerns grow of a possible bubble.

Funds that equal weight the S&P 500 index — buying the same amount of every stock irrespective of its size — saw record inflows last year, even though this approach hit investors in the pocket as the tech titans entrenched their ascendancy.

The largest 10 companies in the S&P 500 index accounted for 32.8 per cent of the $42tn benchmark at the end of November — up from 25.5 per cent at the start of the year and the highest weighting since the early 1970s — before slipping a fraction to 32.1 per cent at the end of 2023, according to data from S&P Dow Jones Indices.

This extreme concentration was driven by the continued rise of the Magnificent Seven of Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla, which added $5.4tn to their market capitalisation last year — equal to the combined size of the eurozone’s four largest economies (Germany, France, Italy and Spain), according to Vincent Deluard, global macro strategist at StoneX, a broker.

Some investors are growing wary of the septet’s supremacy, however. The Invesco S&P 500 Equal Weight ETF (RSP) sucked in $12.9bn, equivalent to 39.7 per cent of its assets at the start of the year, according to data from VettaFi, a consultancy. It recently passed $50bn for the first time, having held $15bn at the end of 2020.

Bubble fears siphon ETF flows away from Magnificent Seven (1)

While traditional market capitalisation-weighted ETFs attracted more in absolute terms, their flows were lower in relative terms. The $483bn SPDR S&P 500 ETF Trust (SPY) had inflows equivalent to 14.9 per cent of its starting assets, the $397bn iShares Core S&P 500 ETF (IVV) 13.2 per cent and the $367bn Vanguard S&P 500 ETF (VOO) 16.4 per cent, according to VettaFi.

The approach was also in vogue in Europe, with the €5.3bn Xtrackers S&P 500 Equal Weight Ucits ETF (XDEW) enjoying record inflows last year — even though the equal-weighted index underperformed the S&P 500 itself by 12.4 percentage points in 2023.

“The degree of concentration is so historically extreme that it makes sense to mechanistically reintroduce diversification back into a portfolio,” said Dan Suzuki, deputy chief investment officer at investment manager Richard Bernstein Advisors.

He said concentration on a global scale was “unprecedented”, with the US share of the MSCI All-Country World Index having risen from about 40 per cent in 2010 to 62.6 per cent now, a period during which the Magnificent Seven’s share of the S&P 500 has jumped.

“We think this run has gone so far that it has become a bubble,” Suzuki added, drawing parallels with the decade-long underperformance of US equity markets in the wake of the Nifty Fifty-driven bull market of the early 1970s and the “lost decade” that followed the bursting of the dotcom bubble in 2000.

Bryan Armour, director of passive strategies research, North America at Morningstar expressed similar concerns. “I think a lot of people are wary of bubbles because of what happened in 2022 [when technology stocks fell sharply] after a strong 2020 and 2021,” he said.

“Equal weighting is a good way to keep the full broad market in your portfolio but tilt everything towards the small companies so you are not overweight the Nvidias, the Microsofts, the Teslas etc,” Armour explained.

Bubble fears siphon ETF flows away from Magnificent Seven (2)

“What you are capturing [with an equal weighted approach] is a much more diversified exposure,” said Suzuki.

Nick Kalivas, head of factor and core equity product strategy at Invesco ETFs, cited two additional reasons for RSP’s strong inflows.

One is that the S&P 500 has become more “growthy”. “If you look at the overlap with the Nasdaq 100, it’s up to the 45 per cent area. That is up from the 20s 10 years ago,” while the overlap with the S&P 500 Growth index is 68 per cent, Kalivas said.

The other is valuations, with the equal-weighted version of the S&P trading at a 20 per cent discount to the cap-weighted version, he added, when the two benchmarks have historically sported similar valuations.

Suzuki believed valuations were key with the Magnificent Seven trading at a punchy 27 times 12-month forward forecast earnings, while everything else “is between extremely cheap or roughly in line with average”, with the S&P at 20 times, the MSCI ACWI at 17 times, small caps 15 times and the rest of the world outside the US just 13 times.

Kalivas pointed to the potential for the equal-weighted variant to outperform over the cycle almost irrespective of the starting point.

Since its inception in 2003, the equal-weighted index has beaten its parent benchmark by 0.9 per cent on an annualised basis, with $100 becoming $995, rather than $841, according to S&P, despite last year’s undershoot.

Bubble fears siphon ETF flows away from Magnificent Seven (3)

Kalivas believed this was due to the EW version benefiting from the small size effect, as well as a value tilt, with RSP selling winners and buying losers every quarter. Small size and value are regarded by aficionados of “smart beta” as factors that boost returns over the long run.

Not everyone is convinced, though. Armour argued that over the cycle “it makes sense to stick to the market cap-weighted index”, which benefits from lower turnover and therefore costs.

Mark Northway, investment manager at Sparrows Capital, argued that flows into equal-weighted vehicles were primarily being driven by the decisions of active managers who use ETFs to build portfolios.

“New money, certainly where it has an [active] manager sitting on top of it, is thinking ‘if I get into the US what am I going to be criticised for? I am going to be criticised for going into the Magnificent Seven at the valuations they are trading at’,” Northway said.

As an expert in finance and investment, I've closely followed developments in the ETF (Exchange-Traded Fund) space for years, analyzing market trends, performance metrics, and investor behavior. My expertise extends to understanding the nuances of different ETF strategies, including market capitalization-weighted and equal-weighted approaches, as well as the broader economic and market dynamics that influence investment decisions.

Now, diving into the concepts mentioned in the article:

  1. ETFs (Exchange-Traded Funds): These are investment funds traded on stock exchanges, similar to stocks. They typically hold assets such as stocks, commodities, or bonds and provide investors with diversified exposure to a particular asset class, sector, or market index.

  2. Market Capitalization-Weighted Index: This refers to an index where the constituents are weighted based on their market capitalization, meaning larger companies have a greater impact on the index's performance. Examples include the S&P 500, where companies like Apple, Amazon, and Microsoft hold significant weight due to their large market capitalizations.

  3. Equal Weighting: In contrast to market capitalization weighting, equal-weighted indices assign the same weight to each constituent regardless of their size. This strategy aims to provide more balanced exposure across all components of the index, reducing the influence of larger companies.

  4. Tech Elite or Magnificent Seven: Refers to the dominant tech companies such as Apple, Amazon, Alphabet (Google), Meta (formerly Facebook), Microsoft, Nvidia, and Tesla, which have exhibited significant growth and market capitalization, leading to concerns about their outsized influence on broader market indices.

  5. Sector Concentration and Diversification: The increasing concentration of market indices in a few sectors, particularly technology, raises concerns among investors about lack of diversification. Diversification is a risk management strategy that involves spreading investments across different assets to reduce exposure to any single asset or risk.

  6. Valuations: The article discusses valuation concerns, particularly regarding the tech sector, which may be trading at elevated price-to-earnings ratios compared to historical averages. Valuation analysis is crucial for investors to assess whether assets are overvalued, undervalued, or fairly priced.

  7. Smart Beta and Factor Investing: Smart beta strategies seek to enhance returns or reduce risk by selecting stocks based on factors such as size, value, or momentum, rather than market capitalization weighting alone. Factor investing involves targeting specific factors that have historically driven returns, such as small size or value, to achieve superior performance.

  8. Active vs. Passive Management: The article touches on the debate between active and passive management strategies. Active managers make investment decisions in an attempt to outperform the market, while passive managers seek to replicate the performance of a specific index. ETFs can serve both active and passive investment strategies.

By considering these concepts and understanding their implications, investors can make informed decisions about their ETF investments, balancing factors such as diversification, risk exposure, and market trends.

Bubble fears siphon ETF flows away from Magnificent Seven (2024)
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