What to know before investing in a Magnificent 7 stock fund

Year to date (YTD) as of November 6, 2023, each of the Magnificent 7 stocks were up 90% on average. While there was a range around this average, the lowest performer among them — Apple — still returned 40% during that period. Nvidia was the standout, up over 200% YTD.

How does this performance compare to the rest of the S&P 500 (the Index)? The Index as a whole was only up 1.7% on average during the same period.

“I think the market is looking for exceptional growth,” says David Wong, Chief Investment Officer, Managing Director and Head of Total Investment Solutions at CIBC Asset Management. “And if you look at the Institutional Brokers’ Estimate System’s (IBES) 12-month earnings growth profile of the Magnificent 7, they’re averaging about 26%, with Nvidia leading the pack with 67%. Earnings growth expectations for the rest of the market are only around 13%.”

In other words, investors have been willing to bid up the price of Magnificent 7 stock to participate in this growth potential. Average forward earnings multiples for the Magnificent 7 is at 30 times, versus 20 times for the rest of the S&P 500.

Taken together, the Magnificent 7 stocks represent USD $11 trillion in market capitalization. That’s roughly 30% of the entire S&P 500. 

This kind of market concentration at the top of the S&P 500 is not new. It first began to be noticed in 2010, when the top 10 names in the Index accounted for around 20% of its market capitalization. Now it’s the aforementioned 7 names alone accounting for almost 30%.

This bunch-up at the top has profound implications for active fund managers and investors.

“In terms of just focusing on the principles of active management, if you’ve got diversification as one of your principles, it’s very hard for a manager to get to an active weight in Apple or Microsoft,” says Wong. “For example, if you got to a 4% active weight of Apple in your fund benchmarked to the S&P 500, you’d be violating the National Instrument 81-102 concentration limit of 10% name exposure. Opens in a new window.”

Active fund managers take many factors and measures into consideration when deciding whether or not an equity belongs in a fund. One such metric is a company’s price-earnings (P/E) ratio. This is a common stock’s current market price, divided by annual per share earnings. This ratio is a short way of saying that a share is selling at so many times its actual or anticipated annual earnings. 

“Nvidia’s trailing P/E ratio is at 110. This means an active manager needs to be really, really confident in Nvidia’s growth profile and growth prospects coming through to feel comfortable owning a name like that.”

Taken together, these headwinds have made it difficult for U.S. equity fund managers to beat the S&P 500 this year.

As Wong notes, “There are over 1,000 active managers of U.S. equity funds in eVestment’s US Large Cap Equity Universe Opens in a new window..”

“YTD as of October 31, 2023, the median manager in this Universe is behind the S&P 500 by about 440 basis points.” 

Because hindsight is 20/20, a passive investment would have been more attractive over the same time period, like the CIBC U.S. Equity Index ETF. This is because it would have fully participated in Magnificent 7 exposure, unlike the median active manager.

But there is a silver lining for active fund investors. In the year 2000, the top 10 names in the S&P 500 represented about 26% of its market capitalization. The tech bubble burst and there was a de-concentration of names in the Index over the ensuing decade. Active US fund managers outperformed the S&P 500 in nine out of those 10 years.

“We don’t know when that concentration will unwind, but we know historically it always has,” says Wong. “At some point, active S&P 500 fund managers will once again have this tailwind in their favour.”