by Connor Darrell, Head of Investments
After a bumpy start to the week, markets ended the first half of the year on a high note, with financial stocks leading equity indices higher. The Federal Reserve’s annual stress tests revealed that banks appear to be on sound financial footing, and bank stocks rallied on the news. However, Friday’s rally could not erase losses from earlier in the week, as global equities traded lower amid ongoing trade tensions.
As geopolitics and trade have dominated headlines in recent months, U.S. small cap stocks have managed meaningful outperformance due to their more domestic focus. The Russell 2000, which measures the returns on a broad basket of US small cap stocks, has outperformed the S&P 500 by about 5% year-to-date.
Tech is Taking Over, and It’s Given the S&P 500 a Serious Boost
As technology has become an increasingly important part of our daily lives, it has also become an increasingly dominant influence of stock market returns. The S&P 500 currently has a total market capitalization of about $23 trillion, and technology stocks make up about 23% of that number. The index’s four largest constituents (Apple, Microsoft, Amazon, and Facebook) are all deeply entrenched in the tech community. Those four stocks make up over 12% of the index, up from 5.9% just five years ago. The rapid rise of the so-called “FAANG” stocks (which include Facebook, Amazon, and Apple along with Netflix and Google) has been a major driver of S&P 500 performance over the last several years.
The proliferation of passive investing in recent years has largely coincided with tech’s dominance, and it begs the question as to whether there are risks lurking beneath the surface. Portfolio managers often seek to minimize the risk that any one (or four) stock(s) dominate the risk profile of a portfolio. Historical data suggests that the average annualized volatility of a single stock is more than double that of a typical diversified equity portfolio.1 As a result, portfolio managers will tend to underweight the largest stocks in an index in an attempt to more efficiently diversify risk across different stocks. As these tech giants have grown into tech behemoths, that underweight has been a difficult hurdle for stock pickers to overcome.
Passive investing provides a myriad of benefits to investors, including low fees, tax efficiency, and better discipline, but investors need to be aware of what’s in their index of choice. The significant boost that the S&P 500 has gotten from the successes of its largest constituents could just as easily go the other way if the market decides that valuations in those stocks have gotten too stretched.  Source: FactSet, Fidelity Investments (2017)