In 2024, the top 10 holdings, which include the “Magnificent 7” stocks, accounted for a staggering 60% of the Russell 1000 Growth Index (comprised of 395 holdings) in terms of weight compared to only 23% in the 10 years prior. The “Magnificent 7” stocks also contributed nearly 50% of the Russell 1000 Growth’s 33% return in 2024. In the S&P 500, the top 10 holdings, which comprise 30%+ in weight of the index, accounted for over half of its 25% return in 2024.

The continued narrowness of the market only strengthened the challenge of how to appropriately reflect conviction in these mega cap stocks through absolute and relative weightings while positioning portfolios for proper diversification of returns. Ensuring the latter while also remaining in alignment with regulatory diversification guidelines has been especially challenging.

There are two primary guidelines for mutual funds that have come into focus. The diversification guidelines under the Investment Company Act of 1940 (the “5/25 rule”) limit the aggregate of greater than 5% stock allocations to 25% of total portfolio assets. This has become a structural limitation for diversified investment managers in their efforts to actively weight holdings within the Magnificent 7. Managers have circumvented this guideline by converting to a “non-diversified” status, allowing them additional flexibility around their exposure to this concentrated group of stocks.

Diversification guidelines under the IRS 25/5/50 rule (or the “5/50” rule) have also come into focus considering the continued appreciation of Magnificent 7 stocks. This rule states that no more than 25% of the portfolio’s total assets can be invested in a single issuer, and that the aggregate of issuers of 5% and above cannot exceed 50% of the total portfolio’s assets.

Given the constant re-positioning that managers have had to engage in around these stocks to remain in compliance with the 5/50 rule, we’ve seen two index providers, S&P Dow Jones and FTSE Russell, roll out a capping methodology to some of their index families. In late 2024, S&P implemented a 23/4.5/50 capping methodology to its 11 sector indices, stating:

1. No more than 23% of the portfolio’s assets can be invested in a single issuer.
2. The aggregate of issuers of 4.5% and above cannot exceed 50% of the total portfolio’s assets.

FTSE Russell conducted a market consultation in August 2024 that culminated in plans to implement a capping methodology to the Russell US Style Indexes, effective March 24, 2025. FTSE Russell will apply a 22.5/4.5/45 capping methodology that states:

1. No more than 22.5% of the portfolio’s assets can be invested in a single issuer.
2. The aggregate of issuers of 4.5% and above cannot exceed 45% of the total portfolio’s assets.

Given the broad usage of FTSE Russell indices, we will focus on the proposed FTSE Russell capping methodology and its implications.

Using the Russell 1000 Growth as an example, the methodology will be rolled out as follows:

• The close of the March 21, 2025, market session will mark the last trading day that the Russell 1000 Growth Index will not be subject to a capping methodology.
• On the open of the March 24 market session, there will be two versions of the Russell 1000 Growth: the Russell 1000 Growth Index (to which the new capped methodology will be applied and which will be referred to as the R1000G) and the Russell 1000 Growth Benchmark Index (to which no capping methodology will be applied and which will be called the R1000GB).
• Indices will be reviewed quarterly. Capping will be applied to applicable indices if thresholds are breached.

What should institutional investors know?

• The Russell 1000 Growth Index (capped) should not be considered a new FTSE Russell index offering but rather the index as we know it today with a methodology adjustment. It is expected that many 40 Act funds will continue to benchmark against the capped index. Similarly, key index fund providers have told Callan that they will all continue to track against the capped versions of the benchmarks, though some are prepared to offer custom solutions to clients that desire to track the uncapped indices.
• The 4.5% in the 22.5/4.5/45 rule does not imply that stocks at and above this position size will be rebalanced from their current position size to an absolute 4.5% at the quarterly review.
• Separate accounts and collective investment trusts (CITs) are not registered investment companies (RIC), and as such, are not subject to the IRS 25/5/50 rule. Because of this, a separate account or CIT technically could choose to opt into using the Russell 1000 Growth Benchmark Index (uncapped) for comparison purposes, especially if there is flexibility around tracking error guidelines. However, based on Callan’s discussions with managers, it initially appears that the use of the uncapped index will be at the discretion of the client for its account.
• We suggest that investment guidelines within a client’s investment policy statement are reviewed to ensure that the correct benchmark is reflected, given similarities in nomenclature between the capped and uncapped version of the indices.

What does this mean for managers?

Details of the FTSE Russell capping methodology (and FTSE Russell’s comparison analysis of the capped indices vs. the benchmark) have been rolled out slowly to investment managers and clients. As such, commentary on the potential benefits and challenges of this methodology has been limited as few managers have had an opportunity to backtest their own portfolios against the benchmarks with the capped methodology applied. However, passive and active managers have made these points in our discussions:

• Turnover: If thresholds are breached on the capped benchmarks, this creates turnover for both the index (to remain aligned with thresholds and to maintain its buffer within the broader diversification guidelines) and investment strategies, particularly those like index funds that look to track the index closely. If thresholds are not breached on the capped benchmarks, investment strategies that look to track the index closely potentially benefit from less turnover while also remaining well within RIC diversification guidelines.
• Active weightings vs. top benchmark names: In the event of a benchmark re-balancing, managers could have more flexibility to adjust active over- and underweights to top benchmark names to align more closely with conviction.
• Concentration: While the capping methodology could provide some flexibility for managers, benchmark concentration remains an issue—particularly if the market continues to reward the top 10 holdings and because the caps are not designed to position for significant dispersion between the capped and uncapped versions of the index.
• Downside capture: If there is any meaningful disaggregation in performance within the top holdings, managers that have been underweight to the top holdings may not experience the full performance benefit of their position—tough to take if they also weren’t able to participate meaningfully on the upside!

At minimum, there is a lot to digest (at least educationally) with this development, but also a lot that only time and the markets will reveal as the implementation date of this methodology nears and crosses.