S&P gets a makeover in September: What is…

The “Magnificent Seven” heavily influence index funds

Until August, Microsoft, Nvidia and Apple were the engine driving The Technology Select Sector SPDR ETF. Together, these three stocks averaged 48% of the exchange-traded fund, but contributed two-thirds (11%) of the ETF’s 16% year-to-date return.

As these stocks grow larger and larger, so does their weighting in The Technology Select Sector SPDR ETF and other index funds. The rise of the “Magnificent Seven” triggered numerous index weighting caps designed to prevent overconcentration of index funds. In particular, Nasdaq conducted a special rebalancing of its flagship Nasdaq 100 index in 2023 to address overconcentration. Now, it’s S&P’s turn.

At stake is qualification for treatment as a regulated investment company. RICs can pass through profits to shareholders. Not qualifying as a RIC means being taxed as a normal corporation – taxing both the fund and its shareholders on capital gains and income. Investors would be rightfully upset if their ETF didn’t qualify.

The requirements are simple for RICs (although they require some mental gymnastics):

1. No more than 25% of assets may be invested in a single issuer.
2. The sum of the weights of all issuers representing more than 5% of the fund must not exceed 50% of the fund’s assets.

Index providers include these limits in their indexes to avoid running afoul of the IRS.

The S&P Select Sector Indices have some safeguards. First, it limits the weighting of individual names to 23% of assets. Second, they only allow the allocation of 50% to companies with weights greater than 4.8%. For indices above this limit, S&P previously reduced the weighting of “the smallest company whose weighting is greater than 4.8%” until the concentration of these names was again below 50%. This also created a buffer before the capped stock breached 5% and triggered the RIC rules.

The S&P Technology Select Sector Index tests these limits. The recent performance of Microsoft, Nvidia and Apple has brought all three over 5% individually and over 50% of the portfolio collectively, causing index constraints to push the smallest of the three to an unexpectedly low weighting . Here are the top three holdings of The Technology Select Sector SPDR ETF XLK as of Friday, September 13 (index reference date):

• Microsoft MSFT (21.95% weight in The Technology Select Sector SPDR ETF)
• Nvidia NVDA (20.09%)
• Apple AAPL (4.86%)

Despite roughly equivalent market capitalizations at the index’s last rebalancing (June), Apple’s weighting was reduced to satisfy the diversification rule, replacing Nvidia as the third-largest stock in the index and globally. Here are the top three holdings of The Technology Select Sector SPDR ETF as of Friday, June 14 (the benchmark date for its June rebalance):

• Microsoft MSFT (22.13%)
• Apple AAPL (21.94%)
• Nvidia NVDA (6.02%)

In June’s rebalancing, The Technology Select Sector SPDR ETF was forced to sell about $10 billion of Apple and buy nearly as much of Nvidia, after the former’s market cap was displaced by the latter.

Index fund investors have grown increasingly skeptical of the sector index’s weighting scheme since Apple regained the No. 2 spot shortly after the rebalancing, creating the potential for another massive rebalancing to comply with the index’s rules. A month-long consultation with market participants led to an eventual change in S&P’s Select Sector Indices and thus State Street’s suite of Select Sector SPDR ETFs.

The rule change, which will be reflected in portfolios on Monday, September 23, will maintain the same diversification requirement: “the sum of companies with more than 4.8% cannot exceed 50% of the total weight of the index.” The change comes in how this requirement will be implemented. Instead of just cutting the weight of the smallest large holding, the weights of all stocks above that 4.8% threshold will be reduced in proportion to their market capitalization.

The Technology Select Sector Index and the funds that track it will be most impacted by this change.

Ripple effects

Funds that track the S&P Select Sector indexes claim $300 billion in assets, with The Technology Select Sector SPDR ETF the largest. The ETF will reset its weights alongside the index at the close of the market on September 20. Illustrated below, the SPDR Technology Select Sector ETF will increase its holdings in Apple while reducing its holdings in Microsoft and Nvidia. The net changes between the top three will be distributed to the rest of the portfolio, which should get a slight boost.

Microsoft and Nvidia Down, Apple and the Rest Up in the Select Technology Sector The Next Rebalancing of the SPDR ETF

Source: Morningstar Direct. Author’s calculations. Old weight as of September 13, 2024. New weight as of September 20, 2024 (estimated estimated weight).

Apple will triple its stake in The Technology Select Sector SPDR ETF when the changes take effect, prompting the ETF to buy more than $7 billion of its shares on Sept. 20. ETF trading in Apple shares is likely to account for more than half the stock’s average daily volume over the past one-month, three-month and one-year periods. Microsoft is also likely to see a major spike in activity that day.

The Technology Sector Select SPDR ETF trades as a percentage of its historical average daily volume

Source: Morningstar Direct. Author’s calculations. Values ​​are estimated for September 20, 2024.

The high volume is not unexpected around the scheduled rebalancing of The Technology Select Sector SPDR ETF. Its June 2024 rebalancing saw trading volume in its top 10 holdings measure about 250% of their one-year daily average, on average, far outpacing just the ETF’s rebalancing. Past rebalances look pretty much the same.

The Technology Select Sector SPDR ETF isn’t the only market mover on the third Friday of March, June, September and December. Other S&P index funds, including the widely watched S&P 500, rebalance on the same day. While many of these indexes are not expected to significantly change holding weights, such as the Technology Select Sector Index, the more than $1 trillion that tracks these indexes has the power to move the markets.

The index effect – a phenomenon where stocks added to an index experience a price increase – is hotly contested. There is little conclusive evidence either way, but the forced buying and selling of large index funds is something investors in funds and stocks should be aware of. In equities, high volume is usually associated with high volatility, and the expected high volume among the constituents of The Technology Select Sector SPDR ETF may lead to additional volatility around September 20.

Long-term investors should look away, but short-term traders should understand the risks and opportunities of trading around index rebalancing.

The author(s) do not own shares in any of the securities mentioned in this article. Learn about Morningstar’s editorial policies.