Time to tap the brakes on your Magnificent Seven exposure?

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Originally published at: Time to tap the brakes on your Magnificent Seven exposure? – InvestEngine Insights

For the past several years, investors have been captivated by a narrow group of Technology-focused stocks that have propelled the U.S. market to new heights.

Dubbed the “Magnificent Seven” by industry pundits, Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOG), Tesla (TSLA), NVIDIA (NVDA) and Meta Platforms (META) collectively represent only 1% of the total stocks in the S&P 500. However, as of May 2024, these mega-cap giants account for 31%1 of its market cap and were responsible for over 58%2 of the S&P’s total earnings. Only five years ago, these same stocks comprised only 17% of total S&P market capitalization.3 

This incredible performance has been driven by several significant factors, including these companies being at the forefront of cutting-edge technologies such as artificial intelligence (AI), cloud computing, and electric vehicles. Additionally, the Magnificent Seven have developed substantial market dominance in their respective industries, contributing to their consistent revenue and profit growth.

However, with the recent surge in market volatility4 – especially in the Technology sector – it is apparent that there are two sides to the Magnificent Seven sword. On one side, investors are staying the course and remain fully committed, believing that the best is yet to come. Others, however, are seeking to diversify from their Magnificent Seven allocation, believing the potential for these stocks to continue advancing at their previous pace remains highly questionable.

While the benefits of owning these equities over the past several years have been, indeed, magnificent, perhaps it is time to take a look at the potential concentration risk created by owning this slice of high-flying stocks as part of several of the major indices. Besides the S&P 500, the Magnificent Seven represent a substantial weighting in the Nasdaq 100, Russell 1000, MSCI World, MSCI ACWI, and FTSE All-World. Investors who track these indices are potentially vulnerable not only to specific company risk due to their outsized weighting, but also being overexposed to the Technology sector.

There is more to the U.S. than Big Tech.

Let’s explore two alternative approaches enabling you to remain fully invested in equities, while also reducing possible downside exposures should these market leaders tumble from their current levels.

Approach One: A balanced weighting to each stock

Given investors’ strong preference for U.S. mega-cap Technology stocks, it is no surprise that small- and mid-cap equities have vastly underperformed. But an impending U.S. interest rate cutting cycle, coupled with a moderating inflation environment, can potentially prove to be strong tailwinds to close the large earnings gap between the Magnificent Seven and the remaining S&P 493, supporting the case for an equal-weighted S&P 500 strategy.

How does this strategy work? As its name indicates, the S&P 500 Equal Weight Index provides an equal weighting to each of the stocks within the S&P 500.  And hence every stock, whether large or small, gets an equal opportunity to contribute to the overall return. By the numbers, it looks like this: In an equal-weighted S&P 500 portfolio, each of the 500 stocks are weighted at .20% of the total portfolio at the time of its quarterly rebalance. Instead of Apple Inc. (AAPL), the largest company in the Index, being 7.11% of the total weight of the S&P 500, it would be 0.20% – the same as News Corp B (NWS), the smallest company by market cap (0.006%) in the Index.5

Additionally, the Technology allocation in the S&P 500 Equal Weight Index is only 12.7%, compared to the 31.0% weight in the S&P 500 index.6

An equal-weighted portfolio, while still exposed to market gyrations, would also likely have less volatility versus a cap-weighted portfolio, should the Magnificent Seven suffer a significant downturn. Of course, should these stocks renew their upwards march, an equal-weighted portfolio would likely underperform its cap-weighted counterpart.

Approach 2: Less cluster risk, broader diversification.

Over the past five years, the percentage of U.S. stocks represented in the most popular Global indices has grown substantially. For example, the U.S. market share in the MSCI World Index has grown from 63.1% to 71.8%.7 Not surprisingly, this has also meant that the concentration of Magnificent Seven stocks represented in these indices has also ballooned, creating a significantly larger allocation to the Technology sector.

While global investors have been handsomely rewarded for an allocation to the U.S. market and its Magnificent Seven concentration, any potential reversion, as markets experienced this past August 2024, could be severe and swift. To achieve a more balanced global diversification, a strategy that follows the MSCI World ex-USA Index is constructed to provide exposure to large- and mid-cap companies from 22 global developed markets, while excluding an allocation the United States. This Index holds 870 constituents, offering investors a diverse exposure to global equities.

As with its U.S. equal-weighted counterpart, the Index is much less tilted towards technology stocks, comprising only 8.8% of its portfolio, versus 24.8% for the parent MSCI World Index.8

A strategy that tracks the MSCI World ex-USA Index is a straightforward yet effective solution to strategically adjust the weighting of U.S. equities in a global portfolio allocation.

You can find two Xtrackers products following both mentioned strategies for the S&P 500 Equal Weight and MSCI World ex-USA here at InvestEngine.

  1. Source: DWS as of 05/31/24. Risk contribution is based on 1-year historical variance contribution of a portfolio of the Magnificent 7 as a percentage of the S&P 500 realized variance. Variance contribution is calculated using daily returns over the past year.
  2. Source: Bloomberg Finance L.P., Aladdin as of 04/30/2024. Past performance does not guarantee future results . Index performance assumes dividend reinvestment ; however these figures do not include fees, transaction costs, taxes, brokerage costs or other changes
  3. Source: Bloomberg Finance L.P., Aladdin as of 04/30/2024. Past performance does not guarantee future results . Index performance assumes dividend reinvestment ; however these figures do not include fees, transaction costs, taxes, brokerage costs or other changes
  4. https://www.thenationalnews.com/future/technology/2024/09/04/market-volatility-likely-to-linger-as-us-tech-stocks-continue-decline/
  5. Source: Bloomberg, September 26, 2024
  6. Source: S&P Indices, August 31, 2024
  7. Source: MSCI as of Sept. 30, 2024
  8. Source: MSCI as of September 30, 2024

Glossary

Artificial intelligence (AI): Refers to computer systems capable of performing complex tasks that historically only a human could do, such as reasoning, making decisions, or solving problems.

Cloud computing: The on-demand availability of computer system resources, such as data storage and computing power, without direct active management by the user.

FTSE All-World Index: A market-capitalization weighted index representing the performance of the large and mid-cap stocks from the FTSE Global Equity Index Series (GEIS). The index covers Developed and Emerging Markets.

Mega Cap Stocks: Refers to the stock of the largest companies in the investment universe as measured by market capitalization. While there is no exact definition of the term mega cap, it generally refers to companies with a market cap exceeding $100 billion.

Mid-Cap Stocks: Shares of companies with a market capitalization between $2 billion and $10 billion These companies are larger than small-cap stocks but smaller than large-cap stocks, often representing a balance between growth potential and stability.

MSCI ACWI Index: An index that captures large and mid-cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. The Index covers approximately 85% of the global investable equity opportunity set.

MSCI World ex-USA Index: An index designed to measure the performance of large and mid-cap stocks across 22 developed markets, excluding the United States. This index covers approximately 85% of the free float-adjusted market capitalization in each of these countries.

Nasdaq-100 Index: A stock market index made up of equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange. The stocks’ weights in the index are based on their market capitalizations, with certain rules capping the influence of the largest components.

Russell 1000 Index: A stock market index that is a subset of the larger Russell 3000 Index and represents the 1,000 top companies by market capitalization in the United States.

S&P 500 Index: The S&P 500 is an index that includes 500 leading U.S. companies, capturing approximately 80% coverage of available U.S. market capitalization.

S&P 500 Equal Weight Index: An alternative version of the S&P 500 Index. Unlike the traditional S&P 500, which is weighted by market capitalization, the Equal Weight Index assigns an equal weight to each of its 500 constituent companies. This means each company represents 0.2% of the index at each quarterly rebalance.

Small-Cap Stocks: Shares of companies with a market capitalization typically between $300 million and $2 billion. These companies are often in the early stages of growth and have the potential for significant expansion, making them appealing to investors looking for high growth potential.

Volatility: The degree of variation of a trading-price series over time. It can be used as a measure of an asset’s risk.

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