Forget Diversification - The Latest ETF Industry Trend is Concentration

Invesco S&P 500 Top 50 ETF

XLG

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XLG has been a part of the financial landscape since 2005, but it has experienced a significant surge in popularity in recent years. According to the ETF Central screener, XLG has attracted $3.55 billion in inflows over the last three years.

To put this in perspective, the ETF currently has a total of $7.09 billion in assets under management, meaning that nearly half of its total assets have been accumulated from 2021 onwards.

The appeal of XLG lies in its simplicity and effectiveness. This ETF distills the broad S&P 500 index down to its 50 largest stocks by size, applying a market cap weighting approach. This method provides a clear, straightforward way to overweight mega-cap stocks.

Performance-wise, XLG has been a strong contender, particularly as mega-cap growth stocks, including the so-called "magnificent seven," have led the market over the last half-decade. These dominant stocks have propelled XLG to impressive heights, with its trailing five-year total returns standing at 19.14%, compared to the S&P 500's 15.82%.

However, potential investors should be aware of the concentration risks involved. Currently, heavyweights like Apple, Nvidia, and Microsoft collectively constitute about 34% of the ETF's portfolio.

Principal US Mega-Cap ETF

USMC

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One under-the-radar concentrated active ETF to consider is USMC, managed by Principal Asset Management. What makes USMC particularly interesting is its distinctive investment strategy, which balances a significant active share with minimal turnover.

Active share indicates the degree to which the fund's holdings differ from its benchmark index. As of September 30, USMC maintained an active share of 55.52%. A higher active share suggests that the fund's holdings are quite distinct from those of its benchmark, pointing to more active management.

Turnover refers to how frequently assets within a fund are bought and sold by its managers. With a turnover rate of just 0.5%, USMC exhibits a patient investment strategy, which involves holding securities for longer periods, thus reducing transaction costs and potential tax consequences for investors.

Support for this approach can be found in a study from the Journal of Financial Economics (Volume 122, Issue 2, November 2016), titled "Patient capital outperformance: The investment skill of high active share managers who trade infrequently."

The study concluded that among portfolios with high active shares, those that adopted patient investment strategies—holding securities for over two years—tended to outperform by more than 2% per year. In contrast, funds with high turnover typically underperformed.

USMC's strategy involves not merely following an index but selecting stocks via a proprietary methodology. This method starts with the top 50% of the S&P 500 by market cap. From this subset, the top 10% is weighted by market cap, while the remaining 40% of the top half are weighted based on financial strength. The result is a current portfolio of just 25 companies, not excessively top-heavy.

Performance-wise, USMC has been a strong contender, earning a three-year five-star rating from Morningstar. Over the last five years, it has achieved a total return of 16.11%, slightly outperforming the S&P 500's return of 15.96%. Moreover, it is one of the most cost-effective actively managed equity ETFs available, with an expense ratio of just 0.12%.

iShares Top 20 U.S. Stocks ETF

TOPT

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The newest addition to the concentrated ETF trend is TOPT, launched by iShares on October 23, 2024. In just six days post-launch, TOPT has already attracted $15.4 million in assets under management. This rapid accumulation highlights the strong investor interest in focused exposure to major U.S. companies.

TOPT is designed to track the S&P 500 Top 20 Select Index, which comprises the 20 largest U.S. companies by market capitalization within the S&P 500. This ETF offers investors a pure play on the biggest and, arguably, the most influential companies in the U.S. economy.

As expected, it includes all of the "magnificent seven" tech giants, ensuring a significant allocation to the technology sector, followed by consumer discretionary, communications, and healthcare.

Despite its relatively small AUM and initially lower trading volume, TOPT boasts impressive liquidity, as evidenced by a tight 0.04% 30-day bid-ask spread. It's important to remember that ETF liquidity is largely determined by the liquidity of its underlying holdings, and in this case, the mega-cap stocks that TOPT focuses on are some of the most heavily traded in the market.

TOPT charges a 0.2% expense ratio, identical to that of XLG. However, given the competitive landscape of ETFs focusing on mega-cap stocks, I wouldn't be surprised if iShares decided to implement a fee waiver to attract even more inflows in the near future.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.