This month's brief technology-stock rout reveals an underside for investors of a steady 2017 rally: Shares of giant tech firms are cropping up everywhere, complicating efforts to diversify portfolios.
Alphabet Inc., Apple Inc., Microsoft Corp. and other tech giants are more heavily represented than they were just a year ago in many so-called factor-based investing strategies. Many of these follow indexes that aim to beat or tamp down risk in the broader market, rather than mimic it, by systematically selecting stocks according to observed traits such as low volatility and momentum.
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Technology now represents 11.3% of the $7 billion PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund, which buys the least-volatile S&P 500 stocks. That compares with 2.9% a year ago, according to Invesco Ltd., the ETF's sponsor.
Google parent Alphabet was tapped in February for the first time ever to join. Microsoft joined the ETF in May for the first time since 2012.
The development means investors holding a mix of seemingly disparate funds in the name of diversification could be surprised to find heavy concentrations in the same group of in-favor stocks, making them vulnerable in bouts of selling. Rules-based funds and strategies that gradually added tech stocks could sell them in a downturn, adding to price declines.
"The fear is that if fundamental events cause volatility to rise, these same passive vehicles will sell and exacerbate downside volatility," said Robert Boroujerdi, head of global securities research at Goldman Sachs Group Inc.
Quant-focused hedge funds held $932 billion at the end of the first quarter, according to estimates by HFR Inc. Such strategies, which have long been available to large investors, are increasingly available to investors in the form of mutual and exchange-traded funds. There were some 637 so-called smart-beta ETFs, a catch-all term that includes factor-based investment strategies, at the end of May with a collective $619 billion in assets, according to Morningstar.
While ETFs represent a sliver of the money that follows quantitative strategies, requirements that these funds must disclose their holdings daily make them a window into how lines of quant strategies can blur depending on market conditions.
Apple, the world's largest company by market value, is the biggest position in indexes such as the S&P 500, which ranks holdings according to size. But Apple is likewise a large position in a slew of factor-driven ETFs offered by BlackRock Inc., the world's largest money manager by assets under management, among others.
Apple is the top holding in BlackRock's iShares Edge MSCI USA Value Factor ETF, representing nearly 10% of the portfolio. Value strategies -- the oldest and best-known factor -- broadly seek to purchase shares for less than their underlying business worth.
At the same time, Apple is a large holding in a separate BlackRock ETF that aims to capture momentum, or the investment strategy based on the idea that stocks that have risen swiftly in the recent past are likely to continue to do so in the future.
Apple is the fourth-largest position in the iShares Edge MSCI USA Quality Factor ETF, which seeks out firms with high returns on equity, low indebtedness and stable earnings growth. Apple is also a small holding in iShares' low-volatility stock ETF.
All told, Apple is in five low-volatility ETFs with a collective $14 billion and nine momentum ETFs with $17.7 billion, according to data firm XTF. Alphabet resides in seven low-volatility ETFs and three momentum ETFs, while Microsoft is in 11 low-vol ETFs and four momentum ETFs.
An unusual mix of market moves and longer-term industry trends helps explain why tech shares have come to populate an array of overlapping strategies.
Fast gains in 2017 for the largest U.S. tech and internet stocks came alongside rare placidity. Until early June, the price swings experienced by this group over the previous six months were near the lowest on record, according to Mr. Boroujerdi. Price volatility for big-cap tech stocks fell below that of stocks in the S&P 500's utility and consumer-staples sectors, which are viewed as more staid.
Financial adviser Chad Carlson, in Itasca, Ill., said the perception that Apple is a safe stock to own permeated client conversations in the past few years -- a sign in his view that investors have grown complacent.
Mr. Carlson said one client of his had about 40% of his net worth in Apple, directly and across various funds, but he refused to diversify because of his experience with high returns, low volatility and his assumption Apple's rise would continue.
Until this month, he said, "People took extraordinary risk in Apple without feeling the actual risk."
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(END) Dow Jones Newswires
June 18, 2017 12:50 ET (16:50 GMT)