Nvidia’s Rise Reveals Passive Investing Trap: Morning Brief

Here are the takeaways from today’s Morning Brief, which you can register to receive every morning in your mailbox accompanied by:

Nvidia (NVDA) notched its 43rd record close on Tuesday, bringing its 2024 yield to nearly 175%.

Unfortunately, passive investors who rely on mutual funds and ETFs as investment vehicles have not been able to participate in all of these gains.

Micron (MU), Qualcomm (QCOM), KLA Corp (KLAC) and Lam Research (LRCX) also closed at all-time highs on Tuesday, catapulting the broader S&P 500 Tech index to its own record and increasing its annual high. -return date at an enviable rate of 31%.

But the closest investment partner – the Technology Select Sector SPDR Fund (XLK) – is underperforming its technology sector benchmark by more than 10 percentage points this year.

And the challenge comes from the success of even the biggest names in tech.

The heart of passive investing is risk management through diversification. In theory, a diversified technology index is “safer” than one in which three stocks dominate the index.

But over the past four years, Apple (AAPL), Microsoft (MSFT) and Nvidia have beaten the rest of the market so much that ETFs run into rules and regulations that limit the weight of individual stocks in funds.

In theory, each of these three giants should be weighted at just over 20% of the XLK fund – if they match the benchmark. However, many investors (including this author) were recently surprised to learn that Nvidia only represents 5.9% of the ETF.

This situation will soon change radically. However, this will lead to another complication: Apple’s weight will drop sharply.

After Friday’s close, the XLK ETF will be rebalanced to bring Apple’s 22% share down to 4.5% and increase Nvidia’s 5.9% share to 21.1%, based on Times Of Update estimates.

This all comes from the era of the Great Depression investor protection lawswhich require indices to limit the concentration of individual stocks to earn the “diversified” label.

Investors who like to read prospectuses might appreciate the wonky legalese that explains the need for these changes, as expressed in this document. FAQs and corresponding indexing methodology published by S&P Dow Jones Indices.

In short, four companies – Nvidia, Apple, Microsoft and Broadcom – exceed the critical threshold of 4.8% for individual names in a diversified index. And because they collectively exceed 50% of the total index by weight, the weights of the smallest members are reduced according to a formula until all legal thresholds are met.

The story continues

In total, Friday’s rebalancing is expected to force the sale of $12.7 billion of Apple stock and the purchase of $11 billion of Nvidia.

It’s close to the dollar…