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Nvidia shares fell nearly seven percent on Wednesday following its second-quarter report, which, while stronger than expected, fell short of higher hopes as it only slightly beat estimates.
The chipmaker’s stock is already improving, and this drop appears to have been just a blip.
However, with the S&P 500 also falling following Nvidia’s results, some are raising eyebrows when it comes to the weight that major US tech stocks now have in the market.
It might also have highlighted for some investors the importance of having a diversified portfolio.
Domination: The recent drop in the share price of chipmaker Nvidia also caused the S&P 500 index to fall
For many, the meteoric rise experienced by Nvidia and the other members of the Magnificent Seven will have generated massive returns.
But not all investors are willing to risk their luck on the fortunes of such a small sect, and diversification turns out to be an established investment principle for most astute long-term investors.
Many investors turn to exchange-traded funds, or ETFs, as a way to easily diversify their portfolios by purchasing a collection of stocks in a single transaction.
What is an ETF and what are its benefits?
Being made up of multiple assets, having a low cost due to their passive nature, and being very flexible, ETFs are often popular with investors who want to keep their costs low while also diversifying.
ETFs work by tracking a certain group of stocks and can be traded on an exchange in the same way as an individual stock.
The goal of an ETF is to replicate the set of stocks it tracks, which can be anything from a stock index to bonds, commodities or a specific sector.
For example, investors can find ETFs that track the S&P 500 or the FTSE 100, or they could get more specific with those that track consumer staples or metals and mining.
As a result of being passive investments, ETF fees tend to be much lower than those of actively managed funds.
How risky are ETFs?
Traditionally, ETFs have been considered a relatively low-risk investment due to the spread they offer.
However, with the rise of the US technology sector, ETFs may prove to be a somewhat riskier investment than they would have been before.
Sam North, market analyst at Etoro, says: ‘While the ETF itself has not changed, its risk profile may have evolved.
‘As a result, one could argue that they are not the “same product” in terms of risk exposure. The ETF follows the lead of the S&P 500, but what that index represents in terms of market sectors and company sizes has evolved over time.
‘This change may mean that the ETF no longer offers the same broad market exposure as before, largely due to the increased concentration in technology and other large-cap stocks.’
What’s happening with US tech stocks and what does this mean for ETFs?
Major US technology stocks saw huge gains in value last year.
The Magnificent Seven – Apple, Tesla, Meta, Alphabet, Amazon, Microsoft and Nvidia – are on the rise, and AI has accelerated this growth.
Over the past year, many of what would historically have been considered low-risk, passive tracking funds have seen their weightings change significantly.
Because of their success, these companies now vastly outperform every one of the other 493 companies in the S&P 500. This has meant a good year for the index, but as seen in recent days, it also means that the market is tied to the fortunes of these few companies.
Of the 503 holdings in the iShares Core S&P 500 ETF, the top 10 stocks (seven of which are Mag Seven, and the rest are Eli Lilly, Berkshire Hathaway and Broadcom) now account for 34 percent of the value of the overall portfolio, Brewin Dolphin data shows.
The Magnificent Seven alone account for almost 31 percent of the ETF, while in total the tracker has 41 percent exposure to the technology sector.
Overexposure to the technology sector is an even bigger problem for Nasdaq-linked ETFs, as the index’s technology bias makes it much more dependent on the sector, while its smaller number of components makes the problem worse.
The top 10 stocks in the iShares Nasdaq 100 ETF, which includes each of the Magnificent Seven companies, account for just over 50 percent of the total portfolio, with Apple accounting for just 9.3 percent.
According to Brewin Dolphin, this problem extends beyond US-based ETFs: the top ten holdings in the iShares MSCI World ETF account for 17.5 percent of the portfolio, despite holding a total of 1,431 companies.
Of these ten, Apple, Nvidia, Microsoft, Amazon and Meta are all constituents.
Rob Burgeman, senior investment manager at RBC Brewin Dolphin, says: ‘Over the course of the past year, many of what would historically have been considered low-risk, passive tracking funds have seen their weightings change significantly.
‘Given that many of them are now highly exposed to six or seven companies in particular, it means that the returns they have generated are not really what we would consider low risk.
‘You need to be aware of the risks you are taking as an investor, so you shouldn’t necessarily invest in an open-ended index fund because you’ve assumed it will be low risk.
“If a fund has up to 50 percent exposure to just 10 companies, that’s a high degree of concentration, something that, generally speaking, would not normally be allowed in many actively managed funds.”
What are the alternatives to ETFs?
As tech stocks have risen in value, there has been a rise in “equal-weight” index trackers, which offer the same portfolio companies but lack the overweighting of certain stocks due to their value.
While this reduces investors’ exposure to a small number of companies, it also reduces their ability to benefit from the rapid growth of these companies.
For example, the iShares S&P 500 Equal Weight ETF returned 11.7 percent in 2023, compared with 26.3 percent for the Unequal ETF.
“As with anything, there is a time and a place where an equal-weighted ETF is more favorable,” says Sam North.
‘For example, in a period where there is thought to be a potential rotation out of big tech companies and into other areas of the market, then the equal-weighted S&P 500 ETF might make more sense.
‘Investors who are concerned about the now very high valuations of these stocks, which have led to a significant disparity with the other 493 stocks, could turn to the equal-weighted ETF to mitigate the risks associated with the heavy concentration in these tech giants.’
Meanwhile, for those who want exposure to these tech companies, there are ETFs that deal specifically with that sector.
For example, investors could choose the Roundhill Magnificent Seven ETF or instead pick a slightly broader technology tracker, such as the iShares Semiconductor ETF, which invests in 35 companies.
There’s also the possibility that the Magnificent Seven’s holdings in these ETFs may be starting to wane as other stocks begin to pay off, especially with interest rate cuts in the US looking increasingly likely, according to Lindsay James, investment strategist at Quilter Investors.
She says: ‘With interest rate cuts in the US looking imminent, an improved performance from forgotten parts of the stock market also seems likely, meaning active fund managers can breathe a sigh of relief after a long period of dominance by the Magnificent Seven, which may now be coming to an end.’
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