XLG - XLG: The Bigger They Are The Harder They Fall

2023-09-18 13:05:05 ET

Summary

• The "disposition effect" in behavioral finance explains why investors sell their winners first and hold onto their losers, creating a self-fulfilling cycle.
• The S&P 500's biggest names have been the winners this year, while small-caps have underperformed.
• The Invesco S&P 500® Top 50 ETF is at risk due to its concentration in mega-cap stocks and the potential impact of the disposition effect.

Behavior is the mirror in which everyone shows their image. - Johann Wolfgang von Goethe.

In behavioral finance, there's something known as the "disposition effect." Basically, this is a well-documented anomaly that shows that when faced with losses at the portfolio level and uncertainty, investors and traders sell their winners first while holding on to their losers. This creates a self-fulfilling cycle, and largely explains the "momentum crash" phenomenon whereby big winners have multi-standard deviation selloffs independent of fundamentals.

This has been a year where the biggest names in the S&P 500 (SP500) have been the winners. Small-caps, as we can see by comparing iShares Russell 2000 ETF (IWM) to the SPDR® S&P 500 ETF Trust (SPY) have completely failed to show any relative strength. In other words, the "new bull market" has been concentrated in a way that is massively underappreciated.

I think there's a real risk that the disposition effect soon drastically impacts headline averages that are market-cap weighted. That's why the Invesco S&P 500 Top 50 ETF, also known as XLG, is at the most risk now in my view. XLG is an ETF based on the S&P 500 Top 50 Index. This index comprises 50 of the largest companies in the S&P 500 Index. The fund's objective is to invest at least 90% of its total assets in securities that make up the aforementioned index. The fund and the index are rebalanced annually. This mechanism ensures that the fund consistently holds the top 50 companies, thus reflecting the performance of these market giants.

XLG provides exposure to industries ranging from information technology and healthcare to consumer discretionary and financial services. As such, the fund is well-positioned to benefit from the performance of leading companies across varied sectors. However, it's essential to understand that the fund is not diversified and could experience greater volatility than a more diversified investment. Note that 40% of the fund is Technology.

The fund's focus on mega-cap stocks means that it's heavily weighted towards the largest companies in the market. These companies typically have robust balance sheets and significant resources, making them better positioned to weather economic downturns. Normally, this would mean XLG can be viewed as a defensive play in tough market conditions. But given just how concentrated gains have been in mega-cap companies, this time could be very, very different.

Details on XLG's Holdings/Components

As of June 30, 2023, XLG held 51 individual equities. The top ten holdings of XLG comprised 50.4% of the fund, demonstrating the fund's concentration in mega-cap stocks. The top holdings include renowned names like Apple Inc. (13.71%), Microsoft Corporation (12.11%), and Amazon (5.56%). Other noticeable holdings in the top ten include Nvidia Corporation, Alphabet Inc. Class A & C shares, Tesla Inc., Berkshire Hathaway Inc. Class B, and UnitedHealth Group Incorporated.

As I noted earlier, sector-wise, the fund is heavily concentrated in the Information Technology sector, which makes up about 40.39% of the total portfolio. Other significant sectors include Healthcare (12.76%), Communication Services (12.68%), Consumer Discretionary (12.13%), and Financials (10.07%). The remaining sectors, including Consumer Staples, Energy, Materials, and Utilities, make up less than 10% of the portfolio.

Peer Comparison

Comparing XLG to other similar ETFs can provide a better understanding of its performance and potential risks. Let's consider two commonly used ETFs for this comparison: the SPDR® S&P 500 ETF Trust and the iShares Russell 2000 ETF ((IWM)).

SPY

The SPDR S&P 500 Trust ETF is one of the most popular and widely traded ETFs in the market. It seeks to track the performance of the S&P 500 Index. SPY is a diversified ETF, holding around 500 large-cap U.S. stocks. Unlike XLG, which focuses on the top 50 companies, SPY provides exposure to a broader range of companies within the S&P 500 Index.

Note the ratio of XLG to SPY looks like it peaked.

IWM

The iShares Russell 2000 ETF tracks the Russell 2000 Index, which includes about 2000 small-cap U.S. companies. The fund provides exposure to a broader range of smaller, more volatile companies than XLG or SPY. As such, it could potentially offer higher returns but also comes with a higher risk.

The extent to which XLG has outperformed IWM is staggering and makes it vulnerable to the disposition effect should a global margin call be at our doorstep.

Conclusion: A Risky Bet Against Behavior

XLG offers a convenient and efficient way to invest in the top 50 companies in the S&P 500. It provides exposure to the largest and most stable companies in the market, which normally can be a safe haven during market downturns. However, the fund's concentration in a small number of companies and in the Information Technology sector can pose significant risks right here, right now. To me, this is an avoid.

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