The Magnificent Seven and Market Cap Weighted Indexing

At the end of 2023, the Magnificent 7 (Apple, Microsoft, Amazon, Google, NVIDIA, Meta, and Tesla) accounted for 28% of the S&P 500 index. With many of the largest exchange traded funds and mutual funds tracking the S&P 500 index, numerous investors have chosen to passively track the S&P 500 index with a significant portion of their portfolio.

While the S&P 500 has generally been regarded as a very diversified index, many investors aren’t familiar with the level of concentration that the S&P 500 has in the largest tech companies.

To understand how an index holding 500 companies can end up with 28% of its allocation in only seven companies and the risks that this can present, it’s important to start with an understanding of passive investing.

Efficient Markets and Passive Investing:

In 1970, Eugene Fama published a paper titled “Efficient Capital Markets: A Review of Theory and Empirical Work” to explain his theory of efficient markets. Based on his body of research and the impact it has had throughout the finance world, he was awarded the Nobel Prize in Economic Sciences in 2013 and is often referred to as the “father of modern finance.”

Fama’s efficient market hypothesis is based on the assumption that markets fully reflect available information, and therefore, active management cannot be expected to outperform passive buy and hold strategies. While the efficient market hypothesis provides a framework for understanding markets; it is hotly debated and contested by many well respected and successful investors – most notably Warren Buffett in his analysis titled “The Superinvestors of Graham-and-Doddsville.”

Regardless of the truth or fiction of the efficient market hypothesis – or more likely the extent to which it is true – the efficient market hypothesis has spawned the passive investing revolution. Passive indexing in its simplest form assumes that it is better to own a little of every business and achieve the average market result with minimal fees.

The passive investing approach has grown massively since John “Jack” Bogle brought passive index-based investing to the masses by founding Vanguard in 1975. Now passive index funds are offered by nearly all fund providers and track a wide variety of indices. While it is difficult to know exactly how much of the equity markets are owed by passive investors, there is evidence that over 1/3rd of the US equity market is passively invested.

Key Takeaway:

The efficient market hypothesis initiated the trend of passive investing and low cost index funds.

The Flaw in Market Cap Weighting:

For most individuals, passive investing has been a great approach to building wealth, and likely will continue to be in the future; however not all passive investing is the same. Generally passive investments track a specific index (e.g. S&P 500), but the passive approach can differ depending on how the individual holdings within the index are determined.

For example, three ways to passively invest in large US companies would include:

Market Capitalization Weighting (i.e. Market Cap Weighting): With market cap weighting, the weight of each position within the index is determined by the market value of its equity (i.e. shares outstanding multiplied by its share price). Accordingly, the most valuable companies receive the highest weight.

Equal Weighting: In an equal weighted index, each company receives the same weight as all the others. For example, each of the 500 companies in the S&P 500 equal weight index would represent 1/500th of the index.

Fundamental Weighting: With a fundamentally weighted index, the weight of each position in the index is determined by fundamental company factors such as sales, operating cash flow, and dividends.

While each of these approaches are considered variations of passive investing (with some being more passive than others), they can result in significantly different investment returns and risks depending on the weighting of the underlying holdings.

When all the passive investing approaches are viewed together, market cap weighting is the most common. The prevalence of market cap weighting is the result of the ease in which it can be implemented.

Since a market cap weighted strategy has to hold positions in relation to their equity value, any position whose price increases relative to the other positions has to have a higher weight in the index – which it already has as a result of the price increase. Accordingly, it is very simple to maintain the appropriate allocations in a market cap weighted index fund.

While a market cap weighted approach is extremely common, it’s important to consider the risks that a market cap weighted approach presents. To demonstrate the risks, let’s consider the most recognizable market cap weighted index, the S&P 500.

Key Takeaway:

The most common approach to passive investing is market cap weighting which weights each company based on the market value of its equity.

Reviewing the S&P 500 Index:

As mentioned at the outset, the S&P 500 index is a market cap weighted index comprised of 500 large U.S. companies. While there are 500 companies included in the index, each company’s specific weight is based on the value of its equity. As of 12/31/2023, approximately 28% of the S&P 500 was made up of the 7 largest technology companies (i.e. The Magnificent 7): Apple, Microsoft, Amazon, Google, NVIDIA, Meta, and Tesla. Their weights within the index are represented by the following graphic:

Accordingly, individuals holding an S&P 500 index fund, are heavily concentrated in these seven technology companies. When looking at each of these individual companies, performance over the last 10 years has been exceptional and has led to very high current valuations:

Accordingly, while the equal weight S&P 500 index is trading at 16.6 times earnings and the S&P 500 market cap weighted index is trading at 19.9 times earnings, the magnificent seven are trading between 24-76 times earnings. Although these companies are some of the best companies the world has seen, the question is whether future earnings growth can justify current valuations.

In the simplest form, stock returns of individual companies result from two sources. First is earnings growth of the company. If the earnings grow and investors continue paying the same multiple of earnings, the stock price will go up. The second source of returns is multiple expansion or contraction. If earnings stay the same, but investors are now willing to pay 20 times earnings instead of 10 times, the price will double.

Companies trading at very high multiples of earnings do so because the expectation is that their earnings will grow substantially in the future. If those earnings don’t grow or grow more slowly than expected, there is a significant risk that their share price will decline as a result of multiple contraction.

While we don’t know whether the valuations of the magnificent seven represent a “market bubble” that will burst in the future, the fact is that market cap weighted strategies such as S&P 500 index funds lend themselves to holding a higher concentration of positions in bubble stocks. The reason is that as the market value of a company’s equity increases (which happens significantly before a bubble bursts), the market cap weighted strategy is required to hold more and more of those positions.

Accordingly, a market cap weighted strategy is more susceptible to the effects of a market bubble bursting. For example, when the tech bubble burst in the early 2000s, the S&P 500 returned its first full decade of negative performance. Because of this, it’s important for investors to understand the concentration of their market cap weighted positions and frequently review whether they are comfortable with their concentration in the largest positions.

Key Takeaway:

A market cap weighted strategy is required to increase the weight of a company as its equity value increases (relative to other companies in the index). Accordingly, market cap weighted approaches are generally more exposed to market bubbles.

Is Fundamental Weighting A Better Approach?

For passive investors who are interested in a different approach, an alternative to market cap weighting is fundamental weighting. As mentioned earlier, a fundamentally weighted approach may hold the exact same companies but will weight them within the portfolio based on company fundamentals such as sales, operating cash flow, and dividends.

One of the benefits of this approach is that a company’s weight in the portfolio doesn’t necessarily increase just because their stock price went up. Rather the weight will increase as the company generates more sales, cash flow, or dividends. By weighting the holdings in this manner, a fundamentally weighted approach breaks the link between price and weight.

By breaking the link between price and weight, a fundamentally weighted approach reduces the risk of allocating too much to overvalued companies and too little to undervalued companies. A market cap weighted approach is hampered by this flaw because it’s only determinant for how much of a position to hold is the value of its equity. If the equity value goes up, the market cap weighted approach has to hold more.

By eliminating price as a determinant in the weight of a position, a fundamentally weighted approach reduces an investor’s exposure to bubbles. By nature, bubbles occur when prices increase well beyond what a company is worth. Since increasing stock prices do not influence weights in a fundamentally weighted strategy, there is usually much lower exposure when a bubble bursts.

While reduced exposure to bubbles is certainly helpful when the bubble bursts, it’s important to realize that the performance of strategies with reduced exposure to the bubble usually lag in performance while the bubble forms. Accordingly, individuals utilizing a fundamentally weighted strategy will need to be patient and focus on long-term performance.

Key Takeaway:

A fundamentally weighted approach breaks the link between stock price and weight within the index.

Market Cap Weighting Vs Fundamental Weighting Over Time:

Fundamentally weighted index data is available going back approximately 25 years depending on the specific index. To compare the results, we reviewed the performance of five market cap weighted indices and their fundamentally weighted counterparts for the 25 years ending on 12/31/2023. The annualized results are shown below:

While the performance shown above suggests that a fundamentally weighted index performed well against a market cap weighted index over the entire 25-year period, we were interested to see how this would break down between the first 10 years during the Dot Com bubble and Great Recession and the following 15 years when we’ve had one of the longest bull markets in history.

During the first 10 years from 1999-2008, the market cap weighted annual performance substantially lagged the fundamentally weighted annual performance. This is consistent with expectations due to the Dot Com bubble bursting which would be expected to more significantly impact the market cap weighted strategy.

Key Takeaway:

While the S&P 500 has performed extremely well in the most recent decade, from 1999-2008 the S&P 500 returned an annualized negative return over the 10 year period!

During the next 15-year period, we were particularly interested in seeing how a fundamentally weighted approach would hold up in the US large cap asset class as market cap weighted approaches have been heavily allocated to the large technology companies which have performed extremely well.

As the table above shows, a fundamentally weighted index kept up and slightly outpaced the market cap weighted index for large US companies. The slight outperformance was a much better result than the underperformance generally expected given the smaller allocation that a fundamentally weighted strategy had to the large US technology companies.

In the other four indices, fundamental weighting also continued to show outperformance, albeit much lower than in the initial 10-year period. With the historical outperformance shown, the next question is how much difference the outperformance makes over time.

Key Takeaway:

Fundamentally weighted indices have outperformed the market cap weighted indices over the past 25 years – including slight outperformance during the last 15 years when large US technology companies have performed extremely well.

What Difference Does It Make?

To demonstrate the value that fundamental weighting can create, we assumed $100,000 was invested in each index at the beginning of the 25-year period. The following chart shows the ending balance of that $100,000 based on the 25-year performance of the respective market cap weighted index compared to the comparable fundamentally weighted index:

As the graphic shows, the ending balance for the fundamentally weighted indices ranged from 1.4-2.4 times higher than the market cap weighted indices depending on the selected index. Accordingly, over the past 25 years, a fundamentally weighted approach provided significant value compared to a market cap weighted approach.

While these results are compelling for fundamental weighting, it’s important to remember that 25 years is a limited amount of historical data and within the 25-year period, there were multiple years when a fundamentally weighted strategy significantly underperformed a market cap weighted strategy. Further, there is no guarantee that a fundamentally weighted approach will outperform in the future.

If we break down the performance on a year-by-year basis and compare a fundamentally weighted approach to a market cap weighted approach for the US large cap asset class, we can see significant underperformance in certain years including underperformance for multiple years in a row.

As shown for large US companies, there are many years when a fundamentally weighted approach underperformed the market cap weighted approach including 7 out of the last 10 years (which includes a stretch of 6 out of 7 years from 2014-2020).

Accordingly, investors who enjoyed the long-term outperformance of the past 25 years had to remain patient and willing to underperform for lengthy periods of time.

Key Takeaway:

There are many years and periods where a fundamentally weighted approach will underperform a market cap weighted approach. Investors need to understand this from the beginning and remain patient over the long-term.

Performance Comparison Pitfalls:

Another trap that many investors fall into is comparing the performance of a diversified portfolio to a single asset class benchmark like the S&P 500. When investors compare a diversified portfolio to a single asset class benchmark, they are prone to see even wider variations and potentially longer periods of underperformance – particularly when their chosen benchmark is one of the best performing asset classes for years on end (i.e. like the S&P 500 has been over the past 10 years).

During periods when a single index like the S&P 500 is the top performer, it is easy for individuals to consider whether to invest solely in the S&P 500. However, it’s important to remember that S&P 500 is a market cap weighted index that is prone to higher concentration in market bubbles. Accordingly, it performs extremely well as bubbles form but suffers when bubbles burst as demonstrated by its annualized negative (1.38%) return for the 10 years from 1999-2008.

There is no guarantee that the S&P 500 will be one of the top performing asset classes in the future. Accordingly, having a diversified portfolio is important to long-term success.

While we do not know the future and certainly cannot guarantee that a fundamentally weighted strategy will outperform going forward, we do think it is worth considering the potential benefits of this approach. Specifically, the underlying logic of a fundamentally weighted strategy and how it reduces an investor’s exposure to overvalued companies and bubbles is worth considering while creating a long-term investment strategy.

Key Takeaway:

Comparing the performance of a diversified portfolio to a single asset class benchmark sets an investor up for inaccurate information and faulty comparisons.

Conclusion:

With the growth of passive investing over the last 50 years, many individuals are in “set it and forget it” mode when it comes to their investments. Most of these passive investments are in market cap weighted strategies.

While market cap weighted strategies offer a low-cost simple way to invest, they also present risks and can expose investors to concentration in companies that have high valuations. Currently we see this in the S&P 500 where 28% of the index is invested in seven companies. High concentration in highly valued companies can leave investors particularly vulnerable to market bubbles.

Accordingly, it is important to frequently review your investment portfolio and determine whether adjustments should be made to avoid unnecessary risks. One approach would be to consider fundamentally weighted indexing rather than market cap weighted indexing to break the link between price and weight.

For those who would like to learn more about the risks they face in their portfolio and solutions that can help mitigate those risks, our Family CFOs would be happy to meet and discuss ways to help you reach your long-term investing goals. If you are interested in learning more, would love to connect to see if what we do is right for you.