Top-Ten Weightings: What Index Investors Actually Own

A fund that tracks an index is usually assumed to hold that index. In concentrated markets, that assumption breaks down for a reason most investors never encounter: funds face legal diversification limits that indices do not.

An index can be as concentrated as market values make it. A fund is a regulated vehicle, and in both the United States and Europe it must satisfy diversification tests that cap how much can sit in any single holding.

When an index approaches those limits, something has to change. Usually it’s the index.

What the Question Should Actually Ask

Asking are ETFs a good investment tends to produce a debate about costs and active management. In a concentrated market, a more specific question matters:

• What does the fund hold, as distinct from what the index contains
• Is the index capped, and if so at what thresholds
• How often is the cap applied, quarterly or daily
• What happens between rebalances, when weights can drift past limits
• Whether derivatives are used to achieve exposure the cash rules wouldn’t permit

Each is answerable from published documents, and each can produce a fund that behaves differently from the benchmark its name implies.

The US Diversification Rules

The American framework comes from the legislation governing regulated investment companies.

The requirement is often summarised as the 25/5/50 test: no single company above 25% of assets, and holdings weighing 5% or more not exceeding 50% in aggregate. As market concentration rose, index providers responded by building capped versions.

One provider describes launching capped indexes in which constituents are capped quarterly so that no more than 20% of the index weight sits in a single constituent, and the sum of the weights of all constituents representing more than 4.5% does not exceed 48% of total index weight.

Note the buffers. The regulatory limits are 25% and 50%, and the capped index applies 20% and 48%, deliberately leaving room so that ordinary price movement doesn’t push a fund into breach between rebalances.

The European Equivalent

European funds operate under a different framework with the same purpose.

The rules require that instruments invest no more than 10% of assets in securities issued by the same body, provided the combined value of securities in which more than 5% is invested is less than 40%, though index-tracking funds can use a 20/35 rule allowing up to 20% in a single issuer, rising to 35% in exceptional market conditions.

The same framework requires index-tracking funds to use an adequate benchmark, meaning the index must genuinely represent the market it claims to cover rather than excluding major securities within it.

So a European investor buying a fund on a concentrated index may be holding a capped variant of that index, with the largest positions trimmed relative to their market weight.

What Capping Does to Returns

Capping is a deliberate deviation from market weight, and it has consequences in both directions.

When the largest holdings outperform, a capped fund lags the uncapped index, because it holds less of what rose most. When they underperform, it does better. The effect is small in ordinary conditions and becomes noticeable when a handful of very large companies drive index returns.

That’s worth knowing before comparing a fund’s performance against a headline index. The gap may not be tracking error in the usual sense. It may be the cap doing exactly what it was designed to do.

What to Check in a Concentrated Market

• Read the index name precisely, since capped versions usually say so
• Compare the fund’s top ten weights against the uncapped index
• Note the capping frequency, as daily-capped and quarterly-capped funds behave differently
• Check whether derivatives are used, since swap-based structures are treated differently under the rules
• Look at the aggregate weight of positions above 4.5% or 5%, which is the figure the rules actually test

The last one is the most informative single number. It measures how close the portfolio sits to its regulatory ceiling, which indicates how likely further capping is.

Why This Matters More Than It Used To

For most of the period during which index investing became mainstream, these rules were dormant. Markets weren’t concentrated enough for the limits to bind, and index providers rarely had to intervene.

That changed as a small group of very large companies came to dominate major indices. Providers have consulted on and introduced capping methodologies, and special rebalances outside the normal cadence have occurred.

None of this makes index funds a poor choice. It means the relationship between a fund and its benchmark is less mechanical than it was, and that reading the index methodology has become part of choosing a fund rather than a technicality.