In the last couple of years, semiconductor behemoth NVIDIA has catapulted itself to become one of the largest holdings in the Russell 1000 Growth Index, the primary benchmark that large cap growth managers use. NVIDIA stock has been a rocket ship, rising over 2200% in the past five years and nearly 120% year-to-date in 2024. When the index was reconstituted in June, NVIDIA’s weighting grew to about 11%. The company has joined other tech leaders Apple, Amazon, Alphabet, Meta Platforms, Microsoft, and Tesla, known as the “Magnificent 7.” This group collectively accounts for almost 55% of the Russell 1000 Growth Index and an outsized share of the benchmark’s gains in recent quarters and years.
Asset allocation challenges amidst index dominance
Like other Mag 7 leaders, NVIDIA is viewed as a significant beneficiary of the current market trend towards artificial intelligence (AI), which is expected to have a long-term positive impact on Gross Domestic Product (GDP) growth. NVIDIA designs some of the best hardware, supports some of the top software, and is poised to lead the acceleration of computing for several years. As the market has rewarded the hype around AI, NVIDIA has become its poster child, creating a land grab scenario for its chips and pushing the stock to newer and newer heights.
But with its ballooning size in the index, like other index behemoths, active managers are forced to decide what to do with NVIDIA. And, almost more importantly, active managers must determine their position sizing relative to the index’s weightings of Mag 7 stocks. Further complicating the issue is The Investment Company Act of 1940. This law suggests that an allocation of 5% or more to a single security is dangerously large, and to have a “diversified” status, a mutual fund should limit the combined total of such positions to 25% of its assets.
At face value, these limits make sense. Concentration and volatility tend to go hand in hand. As recent history has shown, a few well-known non-diversified funds with large stock positions have enjoyed incredible performance before quickly and publicly eroding. Yet, since the Mag 7 have made up a large portion of the Russell 1000 Growth Index’s returns lately, “diversified” portfolios have typically struggled relative to “non-diversified” peers with larger allocations to names like NVIDIA. However, should the market broaden, as we have seen more recently in 2024, more diversified portfolios should outperform with, in theory, performance generated from more than a narrow band of massive companies.
Diversification isn’t enough
Having covered the large cap growth space for about nine years, I’d argue that whether a fund is deemed diversified doesn’t indicate its true riskiness. Diversification alone may not necessarily eliminate the downside risk or ease volatility. What does matter more is the actual volatility of a portfolio’s most prominent positions or if the manager is biased toward stocks exhibiting a characteristic, theme, factor, sector, industry, etc. Regardless, both diversified and non-diversified funds, with varying position sizes in names like NVIDIA and the rest of the Mag 7, are inherently exposed to idiosyncratic and other risks when compared to the index’s unprecedented current concentrated constitution.
It is essential for investors to carefully look under the hood of their portfolios to evaluate the true risks they are assuming, particularly when allocating among large cap growth managers.
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