As we’ve discussed before, not all indexes are created the same way. One of the major differences, in addition to characteristics such as size and style, can be the weighting scheme.
Once indexes have screened securities that pass eligibility requirements, the index must determine how large each stock should be in the index (Chart 1).
Chart 1: Index creation process
Most major benchmark indexes use market capitalization weights for stocks, so the size of each stock reflects its value in the market. However, active portfolio managers looking to outperform the market might use fundamentals or momentum to increase and decrease stock weights in their portfolios.
Index concentration changes over time
Sometimes, market cap weightings lead to concentration, or “top-heaviness,” in the index portfolio.
Concentration has become a hot topic recently thanks to the so-called “magnificent seven” — each of which has seen their market cap top $1 trillion at some point. Their returns have accounted for the majority of U.S. market returns in 2023. That’s made them an ever-larger proportion of the total market capitalization.
Although this increased concentration has made headlines recently, we see (below) that this isn’t the first time the market has been heavily concentrated. In fact, S&P data shows that the weight of the five largest companies also added to around 25% of the total index back in the 1970s.
Chart 2: Index concentration over time
There are different ways to measure concentration
Today, we look at different ways to measure index concentration. We also discuss why (and how) some indexes tackle concentration.
Some measures are simple
The chart above represents a simple way of looking at concentration; for example, how much of the portfolio the top five or 10 stocks represent.
The chart below shows that even that simple measure varies significantly across market capitalization-weighted portfolios. For instance, the total weight of the top 10 holdings across the Nasdaq-100 Index® (NDX®) is much higher than for the Nasdaq US 500 Large Cap™ Index (NQUS500LC™) or for the Nasdaq US Benchmark™ Index (NQUSB™), the total U.S. market index.
However, all three are more concentrated than the Nasdaq-100 Equal Weighted™ Index (NDXE™), which gives each company a weight of 1% (1/100th of the portfolio) regardless of the size.
Chart 3: Top 10 index holdings
Some measures are more inclusive
Just looking at the top 10 stocks (above) suggests that the Nasdaq-100 is around 2x more concentrated than the Nasdaq US 500 Large Cap™ Index (NQUS500LC™) – a proxy for the S&P 500.
However, the Nasdaq US 500 Large Cap Index also has approximately five times as many stocks as the Nasdaq-100®, which includes the 100 largest non-financial companies listed on Nasdaq.
Another way to look at concentration is to consider how a specific proportion of companies in the portfolio adds to a cumulative weight. Chart 4 shows the data this way.
If we draw a line across the top 10% of symbols for each index, we see that the Nasdaq-100® and NQUS500LC™ are actually very consistent. The top 10 and 50 stocks, respectively, account for roughly the same amount (50%) of portfolio weight, a trend that continues for the whole portfolio (the light and dark blue lines overlap).
Interestingly, viewed this way, the US Broad Market, as represented by the Nasdaq US Benchmark™ Index (grey line), is more concentrated, with the top 10% of stocks adding to almost 80% of the portfolio.
In contrast, the Nasdaq-100 Equal Weighted™ Index results in a straight yellow line, as each security contributes the same additional weight to the total portfolio.
Chart 4: Cumulative index weights can help normalize
Some measures are more complex
Some researchers have developed more sophisticated ways to measure concentration, such as:
- Herfindal Hirshman (HHI), which is measured as the sum of squared portfolio weights (e.g., 5%^2 + 4%^2 + 3.5%^2…), has historically been used to analyze market concentration by regulators for potential antitrust issues surrounding mergers & acquisitions. However, HHI can be used to analyze portfolio concentration by measuring the sum of the squared weights of individual stocks in the portfolio.
- Effective # of Stocks (Breadth) is the reciprocal of HHI (i.e., 1/HHI) and reflects the ‘effective’ number of stocks that are represented in the index. For example, a highly concentrated index with 100 stocks may be effectively represented by only 10 stocks.
- Blending HHI and Breadth is, as this paper proposes, another way of measuring index concentration by blending the HHI and Effective # of Stocks (i.e., Breadth) into a single metric. Using this math, an equal-weighted portfolio has a concentration = 0, whereas a measure closer to 1 indicates concentration in a single asset.
Chart 5: Formula for concentration
Chart 6 shows how this works for three hypothetical 10-stock portfolios – ranging from equal weight to market cap (“base” case) to artificially concentrated weighting.
Chart 6: Concentration example
Across each version, we calculate HHI, Breadth and Concentration. Note in the extreme case, where concentration is “high,” the effective # of stocks (or "Breadth") is close to 1 security (Chart 6).
Applying the blended concentration score to real portfolios
We can easily apply the same math to real portfolios. In Chart 7, we calculate concentration across the S&P Sector ETF Indexes in addition to the Nasdaq-100®, Nasdaq-100 Equal Weighted™, and Nasdaq US 500 Large Cap™ Indexes we looked at earlier.
Chart 7: Concentration across sectors
We see that:
- The Nasdaq US 500 Large Cap™ Index, Tech (XLK) & Consumer Discretionary (XLY) are the most concentrated. Other sector ETFs such as Utilities (XLU), Industrials (XLI) and Materials (XLB) have far lower levels of concentration.
- The Nasdaq-100 Equal Weighted™ Index has a concentration equal to 0% (the lower bound for concentration as described above).
Comparing different measures of concentration in real portfolios
We can even compare how each measure of concentration looks for all of these real portfolios in Chart 8, where we color by concentration (red is more concentrated, blue is less). This shows that:
- The Top 10 weight makes the smaller sector portfolios look more concentrated, whereas the Top 10% of symbols shows that a sector like Communication Services (with 23 stocks) has a similar level of concentration as Financials (with 73 stocks).
- HHI makes NQUS500LC™ look similar to the Equal Weight portfolio.
- Effective # of stocks shows that the Communication Services, Energy, Discretionary & Tech Sector ETF portfolios have notably higher levels of concentration than other sectors.
- Blended score shows NQUS500LC™ now has similar levels of concentration to Tech & Discretionary alone at around 80%+.
- The equal-weighted index consistently has the least amount of concentration across each measure.
Chart 8: Measures of concentration can vary
Why concentration matters for index funds
Index concentration also matters for the index funds that are designed to track their benchmarks.
In order for investment funds (or investment companies) to qualify as a Regulated Investment Company (RIC), they must satisfy certain diversification requirements on a quarterly basis. Generally, investment companies may seek to be treated as a RIC due to pass-through tax treatment.
Pass-through of gains is important for investors. For example, consider the diagram in Chart 9 below:
- A company (stock) earns income, which is then taxed. The balance is either paid out as a dividend or results in its stock price rising.
- Personal investors who own the stock receive those dividends, which adds to taxable income. Then, when they sell the stock, any capital gains are also taxable.
- Mutual funds are usually allowed to “pass-through” dividend income and gains to end investors. If they couldn’t, and mutual funds also paid tax, investors using professionally managed portfolios would receive lower returns than holding stocks directly – which would not encourage the expertise, diversification or economies of scale that mutual funds provide to investors.
Chart 9: Example of pass-through taxation
However, in order for investment funds to receive the pass-through tax treatment, the fund must meet several qualification requirements, including the following diversification rules:
- 50% test: Securities that represent more than 5% of the total assets cannot exceed 50% of the total portfolio.
- 25% test: No single issuer can account for more than 25% of the total assets of the portfolio.
Investment companies and funds should seek professional legal and/or tax advice regarding the qualifications for pass-through tax treatment.
These rules make it important for Index Providers to address concentration. That’s usually done by modifying the weighting system used by the index to ensure that funds tracking the index will be in “RIC compliance.”
How does the Nasdaq-100® reduce concentration?
One recent example where this happened was in the Nasdaq-100®. The index uses a “modified” market-capitalization weighting scheme, which constrains the amount of weight for any given issuer. Specifically, the Nasdaq-100 Index rules specify that during the quarterly rebalance process:
- Issuer weights are capped at 20% of the index if their weights exceed 24%.
- The aggregate weight of issuers whose weights exceed 4.5% is reset to 40% if their aggregate weight exceeds 48%.
The capping process employed at the time of the annual reconstitution in December is even stricter than the quarterly rebalances shown above for March, June, and September.
The Nasdaq-100® also has a special rule that allows securities to be adjusted ‘ad-hoc’ in the event that security weights become extremely concentrated between scheduled rebalances. That occurred back in July when Nasdaq announced the third ‘special rebalance’ in history due to excessive concentration.
How the Nasdaq-100 special rebalance in 2023 reduced concentration
Chart 10 shows how the Nasdaq-100® weights changed from market-cap weights (diagonal gray line) to new weights (dots) in order to reduce index concentration levels. The largest six companies’ weights were lowered (brown dots). Importantly, rather than capping all at the same weight, their sizes were reduced proportionally to their market cap size.
Then, nearly all other stocks receive higher weights (green dots).
Additionally, as we noted here, one thing that makes the Nasdaq-100® different is that it includes any company listed on Nasdaq. The four green dots below the line represent those companies (ASML, AZN, JD, PDD). However, their weight is based on the ADR shares outstanding at the depositary banks, so they may not encompass the whole company's market cap.
Overall, the July 2023 ‘special’ rebalance produced one-way turnover of ~12%, which is higher than historical NDX® scheduled rebalances but still much lower than other ‘active’ indexes.
Chart 10: How Nasdaq-100® weights shifted from market cap weights (diagonal line)
Other indexes modify weights, too
The Nasdaq-100® isn’t the only index to modify its weights to reduce concentration under RIC compliance levels. The S&P Sector Select Indexes (which are the underlying benchmarks for the SPDR ETFs) are a well-known series of funds that also follow a modified weighting approach. Based on their rules:
- Max security weight is around 23% (allowing a 2% buffer for the 25% quarter-end diversification requirement).
- The sum of companies with weights greater than 4.8% cannot exceed 50%.
We can see in Chart 11 how these portfolios compare to market cap weights (diagonal lines). The results are similar to the results for the Nasdaq-100® (Chart 10 above). However, the horizontal lines show that the largest stocks in those indexes are capped in the rules (at 23% and 4.8%) regardless of the relative sizes of the companies.
The results also show that Communications Services Select Index, Consumer Discretionary Select and Energy Select Indexes generally have higher levels of concentration, consistent with the Top 10 and HHI metrics in Chart 8 above.
Chart 11: Other indexes adjust weights
Why does this matter?
Diversification is important for investors, especially those using taxable mutual funds.
We see that there are many different ways of measuring how diversified indexes, and therefore the portfolios that track them, are.
Importantly, although diversification changes the weights in an index, it mostly works to ensure investors receive diversified, tax-efficient exposures.