I went to a talk Wednesday by Stu Hoffman, past Chief Economist at PNC. He included comments on the Magnificent Seven. I had not been following that term that’s applied to seven high-flying stocks. The story he told that bolstered the rationale as to why you should hold a broad-based index fund: the total return of the market over time is very “skewed;” relatively few stocks account for most of the total stock market gains over time. If you invest in an actively managed fund, and the fund does not hold the few stocks that dramatically outperform over time – or enough of them, the fund will trail the market as a whole. And, boy, from what Stu said, we really can see that clearly this year.
Stu said the Magnificent Seven had gained 50% in value this year while the balance of 493 stocks in the S&P 500 had gained 6% in value. Weighting those two results gives the 20% total gain in the stock S&P 500 Index. (The market is up 25% now. Stu obviously couldn’t update for the big market gain on Wednesday.)
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Here are the Magnificent Seven. I show their returns YTD as of Wednesday. Stu’s statement of 50% gain for these stocks this year is an understatement. The worst performer is up 50%. The arithmetic average is more than 100% – more than double in value.
I don’t have their weights of the S&P 500 on January 1 to verify how much they account for the total market gain vs. the other 493. They are 28% of the value of the market now. If they were 10% of the value of the market on January 1, these seven (1.4% of the total number of stocks in the 500) account for 40% of the total market gain for 2023: 100% gain * 10% weight = 10% weighted gain vs. 25% total weighted gain.
We can also get a sense of the skew in returns this year by comparing the return for an S&P 500 fund that weights the stocks it holds by their value relative to the whole to a fund that equally weights all 500 stocks in the S&P 500 – it tries to always own the same percentage value of each of the 500 stocks. The arithmatic average return for all stocks is about half that of the weighted average.
The equal weighted fund may own just 1.4% of its total value in the Seven, depending on its frequency of rebalancing such that each stock is 0.2% of the value of all stocks it holds.
Conclusion: You want to hold a broad-based fund that owns all or almost all stocks. You don’t miss out on the relatively few stocks that account for much of the total growth of the market. This argument is easy to understand this year. Seven stocks (1.4% of the total) account for perhaps 40% of the total market gain of the S&P 500 stocks for the year. If you hold an actively managed fund that misses out on the seven stocks – or holds too little of them – you’re left holding stocks that on average return much lower than the total market return; it’s almost impossible to match the return of a broad-based index funds that owns all of them in proportion to their value to the whole.