Just because a fund is top-heavy doesn’t mean it’s broken.
Much has been made of Nasdaq’s recent announcement about the special rebalance of the Nasdaq-100 index. The reason: Apple has grown to be more than 20 percent of the index and has thrown the idea of the index being modified market cap weighted out the window.
Here in the office, everyone has an opinion about it. Dave thinks it’s the worst index in the world. Jim pointed out that the index isn’t any worse than its much-used and well-known cousins, the S&P 500 and Dow Jones Industrial Average. Then, Paul reminded us that all this hoopla resulted from the need for index-tracking ETFs to meet the IRS diversification rules.
But the real question is simpler than that: Is single-stock concentration always inherently bad when it comes to indexing?
In several cases, an investor interested in tracking a plain-vanilla market-cap-selected and -weighted index will pick an index with more than 20 percent exposure to a single stock. It’s the way of the world.
An index tracking a sector dominated by a major player, such as is the case in energy, serves as a prime example. Exxon Mobil (NYSE: XOM) is the largest U.S. firm by market capitalization. As of Wednesday, its market value was over $411 billion. It’s not surprising that XOM makes up more than 21 percent and 23 percent of the Vanguard Energy Fund (NYSEArca: VDE) and iShares Dow Jones U.S. Energy Sector Index Fund (NYSEArca: IYE), respectively. The Energy Select Sector SPDR Fund (NYSEArca: XLE) isn’t far behind, with 17.1 percent in XOM.
These are by no means small funds. In all, more than $15 billion is indexed to these products. Investors looking for a market representation of the energy sector should consider holding a large position in XOM. But they should also be aware of the risks associated with holding concentrated positions in any one stock. (Just ask investors in BP what happens when disaster strikes.)
Heavy concentration certainly isn’t unique to energy, either. Telecommunications services is another great example of an industry where large companies dwarf the competition due to size. AT&T Inc. (NYSE: T) and Verizon Communications Inc. (NYSE: VZ) constitute more than 23 percent and 21 percent, respectively, of the Vanguard Telecommunication Services Fund (NYSEArca: VOX). It may seem extreme to have more than 40 percent of the fund’s holdings in two stocks, but that’s simply how the industry works.
And it’s not an issue unique to the U.S. market. Vodafone Group Plc (LSE: VOD) reigns supreme outside the U.S. as the largest premier telecommunications services provider. And as such, VOD makes up a whopping 20 percent of the SPDR S&P International Telecommunications Sector ETF (NYSEArca: IST).
Sectors aren’t alone in carrying heavy single-stock weights. Countries with smaller markets are often dominated by a single company. In many cases, it’s a multinational corporation or an entity that was previously government-run that ends up with an outsized presence in a given single-country equity index. Currently, 10 ETFs tracking single-country indexes have more than 20 percent invested in a single stock.
|Ticker||Fund Name||Largest Holding||% Held|
|EWK||iShares MSCI Belgium Investable Market||Anheuser?Busch InBev N||23.70%|
|EIRL||iShares MSCI Ireland Capped Investable Market||CRH PLC||23.08%|
|EIS||iShares MSCI Israel Capped Investable Market||TEVA PHARMACEUTICAL IND LTD||22.60%|
|EWW||iShares MSCI Mexico Investable Market||AMERICA MOVIL SAB DE CV-SER L||23.58%|
|ENZL||iShares MSCI New Zealand Investable Market||FLETCHER BUILDING LTD||22.81%|
|NORW||Global X FTSE Norway||STATOIL ASA||21.23%|
|ERUS||iShares MSCI Russia Capped||GAZPROM OAO||24.30%|
|RBL||SPDR S&P Russia||GAZPROM OAO||22.73%|
|EWP||iShares MSCI Spain||BANCO SANTANDER SA||20.75%|
|EWL||iShares MSCI Switzerland||NESTLE SA?REG||20.61%|
One company that keeps popping up is Gazprom (GAZP). Three funds hold a considerably large amount of GAZP: the iShares MSCI Russia Capped Index Fund (NYSEArca: ERUS), and the SPDR S&P Russia ETF (NYSEArca: RBL) have it as a top holding, while the iShares MSCI Emerging Markets Eastern Europe Index Fund (NYSEArca: ESR) has Gazprom in the top five. In all three cases, GAZP constitutes more than 22 percent of the fund.
Furthermore, both ERUS and RBL track a capped index, meaning that the index rules adjust the index holdings to be compliant with IRS diversification rules. Otherwise, GAZP would be more than 25 percent of the index.