Catherine Yoshimoto
- Nokia's 70% weight in Finland's index in 2000 and Volkswagen's 27% weight in DAX30 in 2008 showed extreme concentration risks.
- In 2024, the top ten constituents in the Russell 1000, mainly tech stocks, have over 30% weight, the highest concentration level in the index’s 45-year history.
- Fund regulations like the 5/10/40 rule for UCITS and U.S. mutual fund limits aim to prevent excessive concentration and ensure diversification.
Nokia, VW and stock-specific index risk
Sometimes, individual stocks can gain an outsized stock market footprint.
In 2000, during the technology, media and telecoms (TMT) bubble, Nokia reached a peak weight of 70% in Finland’s stock market index.
Once the bubble deflated, the Finnish company’s share price never again reached the same heights.
However, its commercial performance remained impressive for some years: Nokia sold half of all mobile handsets by 2007. That year saw the launch of the iPhone, the first of the smart phones that would eventually put an end to Nokia’s dominance.
Germany’s equity market threw up another example of stock-specific risk later that decade.
During the 2008 financial crisis, several hedge funds built up short positions in Volkswagen shares, thinking that the car manufacturer would go out of business. But their bet went wrong.
On 28 October, the revelation that Porsche had been building a sizeable equity stake in Volkswagen triggered a dramatic short squeeze in the latter’s shares. As a result of the price spike, VW briefly became the world’s most valuable company (replacing ExxonMobil).
At its peak, VW also gained a 27% weight in the Frankfurt Stock Exchange’s DAX30 index, causing the exchange to announce an emergency cut in the stock’s index weight.
This helped deflate the short squeeze and, within a few days, VW’s share price had lost its premium. Short-selling hedge funds lost a reported €30bn during the turmoil, putting many out of business.
The rise and rise of US tech stocks
In 2024 there’s another concentration story in the financial headlines, this time because of the relentless rise of US mega-cap stocks and the country’s technology industry.
By early July 2024, the aggregate weight of the top ten constituents in the Russell 1000 index (seven of which are technology companies) had risen to 34%. This was the highest level of concentration in the index’s 45-year history (see the first chart).
The US technology industry's weight in the Russell 1000 was also at all-time high in July (see the second chart).
In July 2024, technology had three times the aggregate weight of the basic materials, consumer staples, energy and utilities industries (interestingly, in 2007/08 the situation was precisely the reverse).
weight of the top 10 constituents in the russell 1000 index
Source: FTSE Russell, data from data from 17/12/1997-31/7/2024. Past performance is not a guide to future returns.
industry weights in the russell 1000 index
Source: FTSE Russell, data from 17/12/1997-31/7/2024. Past performance is not a guide to future returns
What are fund diversification rules?
In theory, the share price movements that cause such episodes of concentration shouldn’t concern an index provider. After all, an index firm’s job is to measure the stock market, not to dictate how its constituents should be valued.
But things are not as simple in practice. Stock market concentration does pose a problem for the asset managers running equity funds. This is because global fund regulations tell managers not to put all their eggs in one basket.
In the US, for example, mutual funds that market themselves as ‘diversified’ must limit the aggregate share of companies with weights greater than 5% to 25%. If they are ‘non-diversified’, the aggregate share of 5%-plus individual stock weights can reach 50%.
Similarly, the UCITS regulations (which govern the European Union’s mutual funds) set a “5/10/40” rule: funds can only invest up to 10 percent of assets in a single issuer; and any positions worth 5 percent or more of the fund must not exceed 40 percent in aggregate.
How do they affect index design?
Many mutual funds track indices. So, does this mean that an index provider must mirror the fund diversification rules in its index designs?
Not necessarily, because regulators have granted index-tracking mutual funds some leeway, recognising the fact that index trackers may be less likely to incur stock-specific risk. Following this argument, an active fund manager could be incentivised to chase winners, building up large positions in individual stocks.
So in an index-tracking UCITS, the 10 percent individual issuer limit may be relaxed to 20 percent (35 percent in “exceptional circumstances”).
And in 2019, the SEC indicated via a “no-action” letter that it would not enforce limits in a “diversified” US mutual fund if that fund tracked an index.
However, the SEC said, the mutual fund must update its registration statement to say it may exceed the diversification limits, as well as telling shareholders about its new diversification policy.
Concentration happens
From time to time, the collective actions of traders and investors can cause individual companies and sectors to dominate equity indices. Often, these episodes unwind by themselves over time.
But certain clients do require versions of indices that are more diversified by design. In a separate insight, we describe how we design capped indices, addressing potential concerns about index concentration in advance.
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