Many Canadian investors know too well the risk that comes with putting most of their money into one big company.
Nortel Networks Corp. reached a high of $124.50 during the tech bubble of 2000. But as that bubble burst, Nortel’s global sales declined. By the time Nortel was permanently delisted from the Toronto Stock Exchange in 2009, its share price was just 18.5 cents.
Now, with the Magnificent Seven stocks having grown to roughly a third of the S&P 500’s market capitalization, investors may wish to blunt any risk associated with having their portfolios dominated by big tech stocks.
Equal-weight and capped ETFs, such as the newly launched iShares S&P 500 3% Capped Index ETF (TSX: XUSC) and Canadian-hedged iShares S&P 500 3% Capped Index ETF (TSX: XSPC), are options for managing this so-called concentration risk.
“Especially for Canadians, I think this is a movie we’ve seen before. … We live in a country with a relatively narrow stock market, and so we’ve seen these types of effects take shape,” said Hail Yang, director of product consulting for iShares Canada with Toronto-based BlackRock Asset Management Canada Ltd.
“What we found was a bit missing from the market was a solution that delivered a lot of the familiar features of that headline, benchmark S&P 500 while targeting this concentration issue. And so these products basically seek to do that.”
Hitting the market Thursday, with management fees of 0.12%, the RBC iShares ETFs “still reflect the value creation in the real economy, while targeting the perception of concentration risk in mega caps by applying a 3% security-level cap on those holdings,” Yang explained.
This means the Magnificent Seven — Apple Inc., Microsoft Corp., Amazon.com Inc., Nvidia Corp., Alphabet Inc., Tesla Inc. and Meta Platforms Inc. — would have their weights capped at 3%, with excess weight redistributed to the other uncapped companies in the S&P 500.
“The fact that so much of your investment dollars when investing in the S&P 500 are invested in those seven companies, and that so much of your performance, whether it be up or down, is contingent on the performance of those companies, is a growing area of concern for many investors,” Yang said.
The $1.03-billion Invesco S&P 500 Equal Weight ETF (TSX: EQL) offers another opportunity for investors looking to diversify while reducing concentration risk. Its management expense ratio is 0.26%.
The fund invests in either securities of Invesco S&P 500 Equal Weight ETF (NYSE Arca: RSP) or in securities of U.S.-listed companies to replicate the S&P 500 Equal Weight Index, which has the same constituents as the cap-weighted S&P 500.
The underlying stocks have equal weighting in the fund, meaning Apple Inc. could have the same 0.2% weight as, say, The Hershey Company.
“Naturally, you will have only a 2% exposure to the top 10 companies, because each stock is 0.2%. And of course, this could drift throughout the quarter, but then it will be rebalanced back to 0.2%,” said Darim Abdullah, vice-president and ETF strategist with Toronto-based Invesco Canada Ltd.
“So, you could see that introducing the equal-weight strategy materially reduces the concentration and the contribution risk of the top 10 names.”
The equal-weight strategy also allows investors to “address the valuation stretch and the growth bias that the current S&P 500 index is exposed to,” Abdullah said, allowing them to reap the benefits from lesser-known or smaller companies in the index.
Historically, the top 10 companies in the S&P 500 made up an average of 29.6% of the returns of the index between 1993 and 2023. As of June 30 of this year, that figure is 71.3%, Abdullah said.
As such, the equal-weight strategy is popular among advisors and investors looking to complement or diversify their broader exposure in the S&P 500 market, Abdullah added.
Other capped and equal-weight ETFs include the BMO Equal Weight Banks Index ETF (TSX: ZEB), which holds stocks of the Big Six and is rebalanced semi-annually, and the Harvest Equal Weight Global Utilities Income ETF (TSX: HUTL), which invests in an equally weighted portfolio of 30 companies.
It’s important to note that when market gains are driven primarily by a few large companies, equally weighted and capped strategies will likely underperform.