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Actively Rethinking Index Weightings | The Move Toward Capping
April 28, 2025
Late last year, index provider FTSE Russell made a significant announcement: beginning in March 2025, it would begin capping the weightings of stocks included in the popular style indexes, such as the Russell 1000® Growth Index and Russell 1000® Value Index.
In its announcement, FTSE Russell noted that it was making the change because of the “recent increase in market concentration within the large and mega cap growth indexes,” which made it difficult for mutual funds tracking the index to comply with diversification rules that qualify a fund for pass-through tax treatment from the IRS.
To make it possible for funds to both comply with the IRS rules and still replicate index weights exactly, FTSE Russell imposed limits on weightings of individual stocks (not to exceed 22.5% of the index) and on combined weightings of stocks with weights of 4.5% or more (not to exceed 45% of the index in total).
In its reporting on the change, Morningstar noted that the decision to cap weightings would have a significant effect on the growth style indexes. For instance, funds tracking the Russell 1000 Growth Index would need to trim holdings in Apple, Microsoft, Nvidia, Amazon.com, Alphabet, and Meta Platforms.
The FTSE Russell follows a July 2023 decision by Nasdaq to perform a “special rebalance” of the Nasdaq-100 Index. While this was a one-time event (and the changes in the Russell index are ongoing), it was driven by the same concerns about the “top-heaviness” of the index and aimed to “address overconcentration in the index by redistributing the weights.”
Capping index weightings is a longstanding and not uncommon practice. For instance, both S&P and MSCI have a series of capped indexes, and the S&P Select Sector Indexes have long had limits on stock weightings that are similar to FTSE Russell’s (though these were adjusted in late 2024 because of the increasing concentration in the technology sector). However, these indexes are either sector-focused or not widely used.
The FTSE Russell and Nasdaq announcements are significant because they affect core indexes covering a large segment of the broad market. They highlight three key themes:
Index construction is an active process. While indexes are often called “passive,” they are anything but. “Different index providers make different methodology choices,” wrote Karen Umland of Dimensional in February 2024. The decisions made by index providers “shape the investment exposure and returns for index investors,” said Umland, who added that “it is important for index investors to perform due diligence on decisions made by their index provider.”
Index investing has risk. Investors are often confused about the pluses and minuses of passive investing. A 2024 survey of over 8,000 individual investors from Natixis Investment Managers found that 67% of Gen X investors believed that index funds protected them on the downside, and 62% thought that index investing was less risky. Of course, index funds provide market returns on both the upside and the downside. And, as the capping announcements highlight, index funds may be less diversified – and therefore more risky – than actively managed portfolios.
Increasing market concentration is a concern. Recent academic studies have suggested that the growth in indexing may be contributing to the trend. In “From Realized to Expected: The Passive Investing Impact,” Ponya Behmaram finds that “the rising trend in passive could be artificially boosting the prices of highly indexed stocks,” while in “Passive Investing and the Rise of Mega-Firms,” Hao Jiang, Dimitri Vayanos, and Lu Zheng reach a similar conclusion, namely that “flows into passive funds raise disproportionately the stock prices of the economy’s largest firms,” particularly overvalued large firms.
It remains to be seen how common capping methodologies will become in future. However, widespread adoption of capping methodologies would likely mitigate the effects that these researchers observe and accelerate the process of establishing a sustainable balance between active and passive investing.