Two’s company, three’s a crowd — but when index funds hold 100 or 500 of the largest US businesses, it’s a full-blown popularity contest. Today, the top 10 companies in the S&P 500 make up 33.9% of the index’s weight, and just 31 enterprises account for over half. As these big names keep getting bigger, major index providers are stepping in to limit their influence.

Trading places: For many Americans with retirement or investment accounts tied to large indexes, exposure to megacap powerhouses like MicrosoftMSFT

and NvidiaNVDA

has been a good thing — the S&P 500 is up 20% YTD. But regulators have a different view. Registered investment companies must keep the weight of certain stocks below a set percentage — a challenge as tech trailblazers reach new highs. As a result, indexing leaders S&P Global and Russell FTSE are planning significant changes to their indexes.

• At the close of trading today, S&P Global will launch a new index weighting system across their popular sector-specific funds to reduce the weight of tech heavyweights. This change will affect ETFs and mutual funds managing over $350B in assets.
• Russell FTSE floated a similar proposal last month, which could soon impact all its major indexes, including the Russell 2000, to keep large holdings within regulatory limits.

Megacaps Get Capped

Big-name players dominate America’s prominent indexes, but these changes could make sector-specific funds like the Technology Select Sector SPDR Fund ($XLK) or Communication Services Select Sector SPDR Fund ($XLC) more appealing than tech-heavy indexes like the S&P 500 or Nasdaq-100 — especially at today’s high valuations.

• According to Michael Kantrowitz, Chief Investment Strategist at Piper, this shift will “enhance the distribution of weightings more evenly across the indices,” which might help smaller companies gain traction in sector-specific funds.
• However, some investors are concerned that these adjustments could make passive strategies more active, potentially leading to underperformance or missed returns.

What’s really changing? Although the new methodology will apply to all of S&P’s sector indexes — including consumer discretionary, financials, and energy — the biggest impact will be felt in tech and communications. Given how tech-heavy these funds are, it makes sense.

For investors looking for a more balanced fund, sector ETFs could soon be a better fit than broad-market indexes. But for those banking on Big Tech continuing its upward climb, these changes might make them think twice.