Advisors and clients alike can and should be forgiven if they’re enamored by technology stocks. After all, the sector outperformed the S&P 500 by 26% in the first half of 2023 – one of the largest such gaps on record for the first six months of a year.
That upside, which has been largely fueled by artificial intelligence (AI) ebullience, sure has its benefits. Tech is by far the largest sector exposure in numerous plain vanilla domestic equity funds, both active and passive. Judging by inflows to tech and other mega-cap growth-oriented funds, advisors are directing capital to tech and clients are reaping the rewards.
All of that sounds good and it is. But there’s a “but.” That being that tech is getting big for the britches of many indexes. So much so that NASDAQ recently announced a special rebalance of the widely observed NASDAQ-100 Index (NDX).
Another example of tech’s growing proportions is that Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT) combine for 45.53% of the cap-weighted version of the S&P 500 Information Technology Index. Concentration risk, anyone?
Speaking of Concentration Risk…
Seasoned advisors know that one of the preeminent ways of combating concentration risk when it comes to stocks is to considering equal weighting. As proven by the S&P 500 Equal Weight Information Technology Index, it’s possible that when the largest tech stocks are soaring, as is the case this year, equal-weight will leave some performance on the table.
Still, that index is higher by more than 22% year-to-date and it is truly diverse as none of its holdings exceed an allocation of 1.69%. That diversification is pertinent today because as measured by the Herfindahl-Hirschman Index (HHI), concentration is rising in the tech sector.
“Tech’s current adjusted HHI level of 9.6 is in the 99th percentile of observations, indicating an extreme level of concentration for the sector compared to the long-term average of 4.9,” notes S&P Dow Jones Indices. “When concentration has been relatively high in the past, it has subsequently tended to decline.”
Is that a guarantee that the biggest tech stars are in imminent danger of faltering. No, but it is warning that if history repeats, cap-weighted tech strategies are likely to experience a pullback, perhaps before the end of the year.
Another history lesson is warranted. As noted by S&P Dow Jones, the change in tech’s HHI over the past five years – it more than doubled over that period – is unusually large and such increases have previously set the stage for retrenchments.
Why Equal-Weight Tech Matters Today
History doesn’t always repeat, but human behavior usually does and that simple phrase underscores the near- to medium-term viability of an equal-weight approach to tech.
“The tendency of Tech concentration to reverse has important implications for the performance of equal-weight sector strategies,” adds S&P Dow Jones. “Typically, after peaks in concentration (such as during 1990, 1999 and 2002), equal-weighted Tech has outperformed.”
Bottom line: The AI bubble might not burst anytime soon and tech is much healthier today than it was in 1999-2000, but some diversification can be beneficial in terms of adding downside protection with this high-flying group.
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