ETF that amplifies bet on US market leaders highlights concerns

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Fund launches can often act as a form of rear-view mirror, showing us the big market trends that have already taken hold. An important question is whether such trends can continue and how big a call it is to bet on them.

This brings me to a recently launched exchange traded fund. The iShares S&P 500 Top 20 ETF focuses, as the name suggests, on the biggest 20 companies in the US market and should serve investors who expect the biggest constituents to maintain their dominance.

There is certainly some rationale for this. We are all familiar with the stunning returns of the Magnificent Seven, and even broadening this out to the 20 largest businesses leaves us with an impressive cohort. IShares notes that the top 20 contributed more than two-thirds of the S&P 500’s return over the past three years.

The fund itself takes an unsurprisingly concentrated approach, with Apple and Nvidia each representing 15 per cent of assets and Microsoft accounting for nearly 14 per cent, Amazon on 8.3 per cent and Meta on 5.3 per cent.

This ETF rebalances on a quarterly basis — something that would, for example, force it to take some profits on an Nvidia position if the stock enjoyed another fierce run of gains. For those unsure which stocks sit outside the Magnificent Seven but within the top 20, they include the likes of Berkshire Hathaway, Eli Lilly, UnitedHealth Group and ExxonMobil.

Now the S&P’s biggest names have raced ahead, the market does seem unbalanced. There are different ways to respond to that. We’ve seen equal-weight S&P 500 funds grow more popular, and there was also the launch in the UK of a fund that excludes the US entirely, the Xtrackers MSCI World ex USA ETF, earlier this year.

What to make of the S&P 500 Top 20 option? It might act as a happy medium between holding a conventional S&P 500 tracker, if that seems too diversified, and only holding a couple of the US market’s biggest names, and it could work as a punchy satellite holding.

It’s worth noting some similar options are out there: the iShares S&P 500 Information Technology Sector ETF has huge allocations to Apple, Nvidia and Microsoft, for one. A Nasdaq 100 fund also has decent weightings to the tech giants, while diversifying by sector somewhat.

Separately, I worry about how volatile the new fund might be and how exposed it could be to a pullback. This arguably comes down to a question of risk, and just how heavily investors are willing to bet on the sustained dominance of just a few stocks.

The opportunity cost of missing out on a mega cap-led rally may be great, but it is worth reiterating that decent gains can still be made using a broader approach.

The Invesco S&P 500 Equal Weight ETF, for example, has made a sterling total return of 17.3 per cent so far in 2024, behind the nearly 26 per cent return of a conventional S&P 500 tracker but still impressive in its own right.

Considering the downside is also important: the equal weight fund made a tiny 0.7 per cent loss in the bear market of 2022, versus an 8.1 per cent fall for a regular S&P 500 fund.

*Investors Chronicle offers an expert and independent view of the UK investment market. To find out more, visit investorschronicle.co.uk