Microsoft Done, QQQ Fails Diversification Rule
Earlier this week I posted on AAPL 0.00%↑ :
Now let’s look at MSFT 0.00%↑ . Here are the holdings and weights in SPDR Technology XLK 0.00%↑
Here’s the Russell 1000 Growth ETF IWF 0.00%↑ , a popular benchmark for growth funds.
Here are the rules form mutual fund diversification from a PDF titled Comprehensive Regulatory Regime for U.S. Mutual Funds :
All U.S. mutual funds are required by federal tax laws to be, among other things, diversified. Generally speaking, with respect to half of the fund’s assets, no more than 5 percent may be invested in the securities of any one issuer; with respect to the other half, the limit is 25 percent. In other words, the minimum diversification a fund could have is 25 percent of its assets in each of two issuers, and 5 percent of its assets in each of 10 additional issuers. If a fund elects to be diversified for purposes of the Investment Company Act (and most do), the requirements are more stringent—with respect to 75 percent of its portfolio, no more than 5 percent may be invested in any one issuer.
QQQ 0.00%↑ technically violated that more stringent diversification rule as of yesterday's close, although it may not be a forced seller if it isn't claiming to be diversified:
Unless the rules changed, compliance is quarterly, meaning a fund can violate the rule for half the quarter before becoming non-compliant. Last year, XLK reduced its Apple exposure before hitting limits though. I expect funds will move ahead of time rather than risk selling into an illiquid market.
Here’s the ratio of Microsoft to the S&P 500 and technology sector:
As I explained in the post about Apple, the stock can still go higher, but its ability to outperform is contingent on finding new buyers for the forced sellers in funds such as XLK 0.00%↑ and IWF 0.00%↑ and all the funds passively tracking these indexes. Passive, market-cap weighted index funds can no longer track these indexes if AAPL and MSFT continue outperforming. Most likely, these stocks will cease outperforming barring some positive Black Swan that justifies substantially higher valuations.
Conclusion
There are multiple moving parts involved here, but if MSFT and AAPL outperform the tech sector, Nasdaq, growth, passive and closet index funds will be forced sellers. MSFT and AAPL have mechanical, SEC regulatory selling pressure that will prevent them from outperforming tech and many growth funds.
There is no net benefit in holding MSFT and AAPL because their single-stock risk far outweighs their single-stock benefit. As I said of Apple, unless they do something extraordinary that draws in new buyers from somewhere else, the selling from passive funds offsets buying because the more new buyers come in to push the stocks up, the more selling these funds must do. On the other side, any typical bad news story such as missing earnings will trigger selling.
There is also little benefit from owning funds heavily overweight Apple and Micosoft, such as XLK, because in the case where tech does performs so well that these funds don’t have to sell Apple or Microsoft, it’ll be driven by stocks of much lower weight enjoying incredible gains. Even in a bullish scenario, it doesn’t make sense to own the largest stocks or the top-heavy funds.
Now consider the bearish implications. If MSFT and AAPL cannot outperform the tech sector, and they are 50 percent of the technology sector, how likely is it that the tech sector or the Nasdaq outperform the broader stock market? What happens if the major indexes cascade lower on selling pressure and the smaller stocks underperform because of illiquidity? Then these funds are constantly under selling pressure because outperformance by the largest stocks will beget more selling in the largest names.
Or what happens if there’s a bear market and these stocks underperform? If Apple returned to its QQQ ratio low of the 2010s and QQQ fell 40 percent from here, it would work out to $35 per Apple share. For MSFT, a conservative reversal in its ratio with QQQ gives a price of around $115 per share. History shows the largest stocks seldom hold their leadership position through bear markets. Odds are Microsoft and Apple will decline in their market weighting. Combine that with an overall bear market and it’s a recipe for significant underperformance.