Does Your Index Fund Actually Represent the Market?

A key reason for the popularity of exchange-traded funds is their tax efficiency. Status as a regulated investment company is a critical part of that tax efficiency, and funds would bend over backward to stay compliant.

RICs can pass through profits to shareholders; failing this check means both the fund and its shareholders are taxed on capital gains and income. Most index funds don’t have to bend over backward to comply. Their diversified portfolios of stocks or bonds easily pass the two simple diversification requirements of RICs:

1. No company can exceed 25% of the fund’s total assets.
2. The sum of assets in companies representing 5% or more of the fund cannot exceed 50% of the fund’s total assets.

These are sometimes referred to as the 25/5/50 rule. For index funds and ETFs, it’s the index provider’s responsibility to stay under these thresholds. Funds in violation of RIC rules at quarter-end have 30 days to become compliant.

Concentration limits are built into most indexes to prevent funds tracking them from breaking the rules. Index providers typically impose even stricter limits than RIC guidelines to ensure their portfolios never breach each threshold. Overconcentration isn’t a worry in most markets, but providers still embed these rules in case market dynamics change.

Market Concentration Shapes Index Funds and ETFs

Market concentration is not only changing the complexion of many indexes, but it’s also forcing index providers and fund sponsors into difficult decisions for how to manage overconcentration.

At the frothiest corners of the market, popular indexes are quietly changing how their portfolios are built to stay diversified and retain the tax perks of RIC classification. FTSE Russell will apply updated capping methodology to its US style indexes beginning March 21, 2025. S&P tweaked its Select Sector indexes in September 2024.

Indexes and the funds that track them should follow their target market impeccably regardless of that market’s complexion or concentration. A passive small-cap stock ETF should provide an accurate representation of the small-cap market. A passive technology sector ETF should provide an accurate representation of the technology sector. And so on. Representativeness is key.

In their decadeslong history, most broad-based and market-cap-weighted index funds have not had to worry about potentially sacrificing representativeness to retain RIC status. The highly diversified nature of the US stock market has made it one of the best markets to invest in historically, but alarm bells continue to sound about overconcentration. In some corners, indexes must make trade-offs to maintain the RIC label.

Invesco QQQ Trust Is Highly Concentrated

A few big stocks have outsize influence on the direction of the US stock market. Still, popular broad market index ETFs like Vanguard Total Stock Market ETF VTI

, Vanguard S&P 500 ETF VOO, and even Invesco QQQ Trust QQQ aren’t close to violating RIC diversification rules. But Invesco QQQ Trust has had a few scares.

Around half of Invesco QQQ Trust’s assets are invested in its top 10 holdings, but its largest holding, Apple AAPL, collects only 9% of the portfolio, as of Feb. 28. Five companies claim more than 5% of the allocation, and their combined weight is 36%, below the 50% RIC threshold for such holdings. However, the ETF inched too close to the 5%/50% threshold in the summer of 2023, forcing a special rebalance of its benchmark Nasdaq-100 Index.

Tesla TSLA climbed to 4.53% of the Nasdaq-100 Index on July 3, 2023, violating Nasdaq’s own rule stating that all stocks whose weight exceeds 4.5% may not collectively weigh more than 48%. The index was still compliant with RIC rules, but the strong performance of the “Magnificent Seven” stocks—Alphabet GOOGL, Amazon.com AMZN, Apple, Meta Platforms META, Microsoft MSFT, Nvidia NVDA, and Tesla—nudged the portfolio near the “danger zone,” forcing corrective action from Nasdaq.

The danger zone refers to the area between the red and blue dotted lines in the chart below. If the solid red line crosses above the dotted red line, Invesco QQQ Trust is in violation of RIC diversification rules. If the solid blue line crosses above the dotted blue line, Invesco QQQ Trust is in violation of Nasdaq’s 4.5%/48% rule. Any special rebalance is at the index committee’s discretion. Only three have occurred in the index’s life: 1998, 2011, and 2023.

Concentration a Watchpoint for Invesco QQQ Trust

Concentration of the technology-heavy index periodically nears Nasdaq’s limit, but long-term averages show that’s not typical. However, Magnificent Seven tailwinds forced Nasdaq to reweight the portfolio outside of its usual cadence in 2023.

Concentration improved immediately following the rebalance, but the continued ascent of several mega-cap stocks raises the question of if the portfolio could breach those limits more often, forcing more-frequent intervention from Nasdaq. If that happens, representativeness of its target market may have to be compromised to satisfy RIC rules. That point has not come yet, but it’s worth monitoring.

That point has come in some corners of the market, like the technology sector and large-growth segment. In these areas, index providers take deliberate action to satisfy RIC requirements while also attempting to stay as representative of their target market as possible. FTSE Russell is the latest provider to tweak several of its indexes.

Technology Sector ETFs May Not Accurately Represent Their Target Market

The technology sector in the United States is highly concentrated, with a handful of stocks claiming nearly all of the sector’s total market capitalization.

S&P Dow Jones Indices carries two related technology sector indexes: the S&P 500 Information Technology Index and the Technology Select Sector Index. The former is an uncapped, market-cap-weighted portfolio of the roughly 70 information technology stocks in the S&P 500 index. The latter holds the same stocks and also weights them by market cap, but it imposes weight limits to avoid concentration beyond 25/5/50. No US-domiciled mutual funds or ETFs track the uncapped index, while $75 billion in six funds follow the capped Select Sector Index, as of Feb. 28, 2025.

The uncapped index is a more accurate representation of the technology sector. It doesn’t care how large a stock is, it simply weights that stock proportionate to its size in the technology sector, even if the eventual portfolio doesn’t comply with RIC rules. The table below highlights the differences at the top of each portfolio.

RIC Rules Improve Diversification

The Technology Select Sector SPDR ETF XLK is the largest fund tracking the capped index, with over $70 billion in assets. S&P’s Select Sector Indexes currently cap individual holdings at 23%, and no more than 50% of assets can be invested in companies with weights greater than 4.8%--or 23/4.8/50. If the Technology Select Sector Index violates these rules, the weight of each large holding is brought down proportionate to its market cap until the group’s sum is back under the limit. Restrictions like these are common in concentrated market segments.

In these segments, RIC rules may prevent an index fund or ETF from fully and accurately representing its target market—illustrating the effect of active decisions made by index providers. Apple’s weight is 8.2 percentage points less in the capped Select Sector Index than in the uncapped version.

Shown below, strong performance in the market’s largest stocks sometimes translates to a wide performance gap between the two, further highlighting the active risk embedded in some index funds.

RIC Rules Can Hold Returns Back

Most Index Funds Accurately Represent the Market

Through most environments and in most segments, a market-cap-weighted index fund or ETF works perfectly well. But around the edges, and as market concentration grows, index providers may exert more control than before to maintain RIC compliance.

Investors seeking more-concentrated exposure than can be found in RIC-compliant funds can buy individual stocks. Or they can buy one of several highly concentrated ETFs that skirt RIC rules by using derivatives. This is not without extra risk, though. More on them below.

None of this is cause for concern, and the vast majority of indexes don’t have to cap holdings to comply with RIC rules. Index providers retain discretion over their indexes but are rarely forced to act outside of normal business. No action is taken without careful consideration and consultation with important stakeholders. Investors should feel comfortable investing in most index funds, but they should always know the forces that shape them.

Some ETFs Can Skirt RIC Rules, for a Cost

Cash, government securities, and shares of other RICs are exempt from RIC thresholds. Derivatives are also treated differently under the rules, allowing for highly concentrated single-stock ETFs to comply. These and other concentrated ETFs use total return swaps or other derivative contracts to simulate certain market exposures.

Roundhill Magnificent Seven ETF MAGS uses swaps to offer equal-weight exposure to each of the Magnificent Seven companies. Simply holding shares of those seven firms would bring portfolio concentration far above RIC limits, so swaps are necessary. This ETF holds shares of those seven firms but also 10-12 other holdings, according to past portfolio data. Other holdings are total return swaps or cash positions related to the swaps.

Total return swaps are derivatives. They are a contract in which one party will provide the total return of an asset in exchange for financing at a set rate—usually the Secured Overnight Financing Rate plus a spread. For ETFs, the ETF makes payments to the bank, or other counterparty, providing the swap in return for the total return of the asset. Total return swaps are treated differently under RIC rules than regular stock holdings, so achieving highly concentrated exposure is possible without violating any rule.

However, investors bear extra risk and cost if their ETF uses total return swaps.

Derivative contracts come with separate risks to regular stock or bond holdings. These are spelled out in the prospectus of each fund, but they can be summarized as counterparty risk and execution risk. Counterparty risk amounts to how likely the swap counterparty is to pay out its side of the return swap, while execution risk refers to the ability to add or remove swap exposure in a timely, cost-efficient manner. Both risks are small, but they may result in a loss to the fund in rare circumstances.

Total return swaps also come with extra costs. Transaction and financing costs are passed on to shareholders and come out of returns. Additionally, funds using swaps may also charge a higher fee to compensate for its elevated operating costs.

Swaps and funds using swaps are not necessarily bad. It’s up to an investor to decide if a fund using swaps is right for them, but they should know the inner workings before investing.