An oft-mentioned criticism of cap-weighted ETFs — mainly those dedicated to large-cap equities — is that when stocks rally, concentration risk in those funds can increase.
2023 has seen the “Magnificent Seven” group mega-cap growth stocks surge. Concentration levels in some supposedly diverse equity benchmarks, and thus the corresponding index funds and ETFs, are high. For example, at the end of August, the top 10 holdings in the S&P 500 commanded almost 31% of that index’s weight. That situation was amplified with the Russell 1000 Index. As of August 31, the top 10 holdings represented 51.5% of the benchmark’s portfolio.
For advisors and investors looking to dial back on large-cap concentration, one avenue to consider is small-cap funds. Take the case of the Invesco NASDAQ Future Gen 200 ETF (QQQS ). The fund follows the Nasdaq Innovators Completion Cap Index. The index is a descendant of the famed Nasdaq-100 Index, which can be a top-heavy gauge. The largest of QQQS’ 201 holdings accounts for just 1.54% of the ETF’s lineup.
Diminishing Concentration Risk
One of the advantages of a fund such as QQQS is that many market participants aren’t yet paying daily attention to some of the fund’s holdings. That helps diminish concentration risk.
“Higher stock market concentration was associated with smaller firms receiving less investor attention as measured by turnover, analyst coverage, and downloads of firm financial information,” noted Morningstar’s Larry Swedroe.
He pointed out another interesting scenario that’s undoubtedly relevant to investors considering small-cap ETFs such as QQQS. As concentration in large-cap indexes increases, so does the potential efficacy of the size premium. That’s is often cited as one of the primary catalysts for small-cap investing. That scenario is seen over long-term horizons, too.
“The expected size premium (the difference in returns between the first and fifth quintiles) increased during periods of higher stock market concentration,” added Swedroe. “A one-standard-deviation increase in stock market concentration increased the expected returns of small firms by 9.4 percentage points per year. And it decreased the expected return of the largest firms by 0.83 percentage points per year. Most of the effect was caused by the small firms. The effect was statistically and economically significant in both the earlier (1926-85) and later (1985-2021) sample periods.”
Of course, history isn’t guaranteed to repeat. But QQQS currently has the size premium, lack of concentration risk, and historically attractive small-cap valuations on its side. Those could be compelling catalysts for small-cap investors ahead of 2024.
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