S&P's New Index-Cap Rules Apply to Funds With $350 Billion

Index-tracking stock funds with assets worth $350 billion are set for a significant overhaul later this month, following a move by S&P Dow Jones Indices to adjust its rules and address the increasing dominance of the largest companies. In response to the equity market’s growing concentration of Big Tech firms, S&P has announced that it will reduce the weightings of the biggest market leaders in proportion to their capitalization if they surpass certain size thresholds in key industry benchmarks. This change is aimed at mitigating the risk posed by these increasingly dominant companies.

‍

This marks a notable shift from the current methodology, where the smallest companies in a group would be the first to have their weightings reduced once the preset limits are triggered. The underlying issue is the rising concentration risk in the market, especially this year. Investment managers are working to ensure that their exposure to a few booming technology firms doesn't breach long-standing regulatory limits. The new rules, however, will have wide-ranging impacts, as the benchmark provider plans to introduce this capping initiative across various sector indexes, including those tracking consumer staples, energy, and communications.

‍

The change comes after a month-long consultation with market participants and means that passive investment vehicles like the Technology Select Sector SPDR Fund (ticker XLK) will need to adjust their holdings during the next quarterly rebalancing. According to estimates from Piper Sandler & Co., when the new methodology is implemented on September 20, it will trigger $31 billion worth of trades across major exchange-traded funds (ETFs), with around half of that coming from the technology sector.

‍

For the fund industry, this revision is seen as a positive development. Michael Kantrowitz, Piper’s chief investment strategist, noted that the old approach to capping large firms often left investment funds underexposed to key companies like Nvidia Corp. and Apple Inc., which in turn caused volatile trading in these shares earlier in the year. He explained that the new method "appears to be an attempt to better distribute weightings across the indices while reducing unnecessary turnover." This adjustment, Kantrowitz added, should help mitigate tracking errors, which occur when the performance of a capped sector index diverges significantly from its uncapped version.

‍

This move by S&P is part of a broader trend among index providers to adapt to a stock market that has become increasingly concentrated. Last year, similar constraints led Nasdaq to implement a special rebalancing to keep its index-tracking funds in line with regulatory requirements. Additionally, just last month, FTSE Russell held consultations on capping the weightings of the largest members in its U.S. growth and value indexes.

‍

The pressure on index providers stems from long-established diversification rules for regulated investment companies, which prevent any single stock from making up more than 25% of a portfolio. Furthermore, the combined weight of the largest holdings — those representing 5% or more of the index — cannot exceed 50%. These 25/5/50 rules are designed to protect investors from being overly exposed to a few stocks. However, in today’s market, where companies like Nvidia and Apple have grown substantially, these limits can become a challenge for fund managers.

‍

S&P’s new capping trigger levels are set slightly below the 25/5/50 limits to provide a buffer, remaining at 24/4.8/50. While the trigger levels remain unchanged, the way the capping process is carried out is being revised. Currently, three stocks — Apple, Microsoft, and Nvidia — each account for at least 4.8% of the uncapped technology index. Apple leads with a 23% weighting, followed by Microsoft at 22%, and Nvidia at 19%. Combined, their weightings exceed 60%, meaning their proportions will be reduced in line with their sizes to meet the 50% threshold during the next rebalancing. The extra weight from these companies will then be redistributed among the other index constituents, each capped at 4.5%.

‍

Under the old rules, the smallest of these top stocks would have been capped first, meaning Nvidia’s weighting would have been reduced to 4.5%. This scenario played out earlier this year when Nvidia’s stock price surged, leading XLK to underperform the uncapped tech benchmark by 10 percentage points — its worst underperformance on record. At the time, Nvidia's rapid rise led to a rebalancing in June, where XLK bought an estimated $11 billion worth of Nvidia shares, reducing its exposure to Apple in the process. Since then, Apple has outperformed Nvidia, resulting in missed gains for XLK investors.

‍

With S&P’s revised rules, XLK will likely avoid another major reshuffling, even though Nvidia has since fallen behind Apple in terms of market value. This new approach should help the fund maintain a more balanced and stable allocation, reducing the need for disruptive trades and providing more consistent exposure to the sector’s top-performing stocks.

‍