The never-ending rise in technology megacaps is driving stock-picking pros to do something they don’t want to do: give up on beating the benchmark.

With the likes of Microsoft Corp. and Nvidia Corp. all but owning 2023’s bull run, money managers faced a dilemma. So many stocks have been left in the dust that finding ones to beat the index is next to impossible — the hardest since 1987, by one measure. One remedy is to give up and let the S&P 500’s static allocations guide their own.

That’s what they did, in droves. It’s illustrated by something called the active-share ratio, a gauge kept by Bank of America Corp. among others that tracks how holdings of active funds deviate from the S&P 500. Near the end of last year, the indicator hit the lowest level since 2013. Managers are mirroring the index more than any time in a decade.

“Active managers typically justify their fees by producing alpha by security selection,” said Mark Freeman, chief investment officer at Socorro Asset Management LP. “But in a market where returns are being driven by just a handful of large-market-cap names, it becomes increasingly difficult to fulfill that mandate.”

Propelled by the artificial-intelligence frenzy, the seven largest tech firms – also including Apple, Alphabet, Amazon.com, Meta Platforms and Tesla – have doubled on average in the past year. That’s four times as much as the S&P 500.

With gains concentrating in a few names, the rest of the market languished. Only 27% of the S&P 500’s constituents were ahead of the benchmark last year, the narrowest market breadth in BofA’s data history since 1987.

As a result of the wide divergence, the so-called Magnificent Seven saw their market share climb to unprecedented heights. At one point last year, their combined weight in the S&P 500 reached 29%, the most since at least 1980, data compiled by Goldman Sachs Group Inc. show.

Predictably, the boom stirred up fear that a crowded trade risked a rapid unraveling. And to some degree that happened in 2022, when the cohort’s slump fueled a 25% bear-market plunge.

At the same time, concentration alone rarely triggers a selloff. As long as profit growth justifies share appreciations and interest-rate backdrops favorable — as has been mostly the case in the past decade — there’s a dearth of statistical evidence to suggest the tech behemoths can’t keep expanding.

Moreover, concentration in benchmark weighting has the potential to create optical illusions when it comes to fund positioning, specifically the appearance they’re overweight technology. Active managers could make no decision other than to mimic the S&P 500’s makeup and they’d still have more than a quarter of their portfolio in seven computer and internet stocks, for instance.

It’s not owning enough of the big winners that has proved to be a larger problem for money managers. Last year, only 38% of large-cap funds beat their benchmark as an aversion to tech megacaps dragged down performance, according to an analysis by BofA.

“Not holding stocks that are big return contributors to the benchmark carries tremendous underperformance risk when these stocks have positive momentum,” said Savita Subramanian, BofA’s head of US equity and quantitative strategy. “As filings are posted at the end of each period, funds may feel some pressure to show that they held the best companies over that period – particularly if the alpha from top stocks and the index is quite wide, as it was last year.”

Going by her team’s data, active funds have been gravitating toward their benchmark since 2017, a period coinciding with tech’s largely unstoppable ascent. Over the stretch, their active share ratio slipped to 65%, down from a peak of almost 70%. The ratio always falls between 0% and 100%, with zero indicating a pure passive strategy while a higher reading suggests more active management.

The active share ratio did perk up over a stretch when tech’s supremacy was briefly interrupted from late-2021 onwards.

Software and internet shares have extended their leadership in the new year, bolstered by optimism that the Federal Reserve will soon embark on a monetary easing cycle as inflation cools, alleviating valuation pressure on richly valued stocks.

To stand a chance of winning, stock pickers need big tech exposure. Not all of them can get it. Regulations dating back over 80 years set limits on how concentrated a “diversified” mutual fund can be. Under those rules, these funds must cap the number of individual securities that equal more than 5% of their assets, and such stakes can’t add up to more than 25% of their overall portfolios.

“As market cap weighted indicies become more and more concentrated in a handful of names, it creates an inherent conflict for active managers who are not willing or able to have such concentrated positions,” said Freeman at Socorro. “In this environment active managers are just trying to keep up as best they can, which means taking index-like positions to the extent possible.” 

This article was provided by Bloomberg News.