Index Funds' Growing Risk: Overweighted With Tech Securities

When is too much of a good thing really too much? JL

Kenan Machado and Saumya Vaishampayan report in the Wall Street Journal:

The weighing of technology stocks in the S&P 500 index has climbed to 23.8% from 20.8% at the end of last year. The same is true in Asia, where tech stocks have powered gains in Hong Kong, South Korea and other markets. Some tech stocks have gained nearly 50% this year. A pullback in the sector will have a bigger impact on the broader market.
Being passive can leave you with too much of a good thing.
Investors who loaded up on U.S. and Asian stock-index funds might be surprised to learn just what they own now: technology stocks—a lot of them.
Led by Apple Inc., Facebook Inc. and their peers, the weighing of technology stocks in the S&P 500 index has climbed to 23.8% as of Dec. 26, from 20.8% at the end of last year, according to S&P Dow Jones Indices.
Three years ago, tech stocks had a 19.7% weighting in the widely used U.S. stock market benchmark, which is currently tracked by funds with more than $2 trillion in assets. Over the past 10 years, the weighting of the tech sector in the S&P 500 at year-end has averaged 19.6%.
The same is true in Asia, where surging tech stocks have powered sharp gains in Hong Kong, South Korea and other markets. The weighting of technology stocks in the MSCI Emerging Markets Index, whose components include Chinese e-commerce giants Tencent Holdings Ltd. and Alibaba Group Holding Ltd. , was 28% as of Dec. 21, from 23.3% a year ago. Passive funds with $384.5 billion in assets tracked the index at the end of June, according to data provided by MSCI, and the tech sector’s average year-end weighting over the past decade has averaged 17%.
“It’s sort of an inherent flaw of index funds,” said Kyle Moore, founder of Quarry Hill Advisors in St. Paul, Minn., referring to the way surging stocks have a bigger share of indexes that are market-value weighted, like the S&P 500.
Noting that some tech stocks have gained nearly 50% this year, Mr. Moore said a  typical investor response would be to trim exposure to those stocks and take profits. When that happens in an index fund, nothing happens automatically, he said.
Investors have collectively plowed $436.5 billion this year into index funds globally through Dec. 20, according to EPFR Global. For many, the bet has paid off handsomely. The S&P 500 index has climbed 19.8% so far this year and is on track to chalk up its biggest annual gain since 2013. The tech-heavy Nasdaq Composite Index is up 28.9% this year.The conundrum now for investors is whether they should try to reduce their exposure to tech, and how to go about doing it. A pullback in the sector will have a bigger impact on the broader market, but arguably many investors in index funds have accepted that is what they signed up for when they chose to invest passively.
Some investment advisers say they are telling clients to reduce their tech exposure by selling individual stocks or shifting into other funds where tech has a lesser influence.
With a fund that tracks the S&P 500 now, “it’s almost like you’re getting a bit of a technology momentum fund,” said Tom Haggerty, portfolio manager at Retirement Strategies, which manages about $350 million in Jacksonville, Fla.
Mr. Haggerty said he has talked to a few clients with large technology holdings, including those who own specialized exchange-traded funds such as the PowerShares QQQ that tracks Nasdaq-listed stocks. “We have pushed hard to have them pull back on those positions, especially if they hold those stocks in a large-cap fund,” he said.
Gary Sagui, a retired commodity trader who splits his time between Florida and Wisconsin, said he recently became concerned about the increased weighting of large companies with high price-to-earnings ratios in his index funds. That includes so-called FANG stocks—shorthand for Facebook, Amazon, Netflix and Google ’s parent Alphabet.
The 66-year-old said he sold his holdings in a Vanguard Total Stock Market exchange-traded fund and switched to a managed fund from Dimensional Fund Advisors with smaller weightings in such stocks. “It’s not that I don’t think they are great companies,” Mr. Sagui said, adding that “once you get off a regular income and are going to live on a pot of money you’ve put together, the questions you’re going to ask are a little different.”
Gains in tech stocks this year, which have been driven in large part by strong sales and profit growth, have stood out even in a banner year for equity markets overall. Apple and Facebook shares have surged about 50%, and Apple’s market capitalization is now close to $900 billion, making it the most valuable public company in the world. Shares of Tencent and Alibaba have roughly doubled this year.
The higher weighting of tech stocks in major indexes isn’t worrying investors who believe the rally has further room to run because of how well many technology companies are performing and their continued potential for high growth.
“We don’t think it is out of whack,” said Andy Wong, a senior investment manager at Pictet Asset Management in Hong Kong. “The benchmark weighting is a lot higher but compared to the tech bubble it is not there yet,” he said referring to the S&P 500.