Are Index Investors Overlooking Liquidity Risks?

Last year everyone loved the Magnificent Seven - Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla, tech stocks that made up a significant portion of the S&P 500 index and also contributed over half the index return in 2023 & 2024 according to Reuters. The market's biggest companies are dominating like never before. The top 10 stocks in the S&P 500 are trading at an average forward P/E ratio of 30.7, far above historical norms. While this alone raises valuation concerns, an often-overlooked risk is the potential downstream liquidity squeeze these stocks could face due to IRS regulations impacting major index funds.

How IRS Regulations Could Create a Liquidity Squeeze

Many of the largest and most widely held index funds are structured as ETFs and mutual funds that must comply with IRS diversification rules. Specifically, the IRS requires that no more than 25% of a fund’s assets be invested in a single stock and that the sum of the fund’s largest holdings over 5% each cannot exceed 50% of the total portfolio (often referred to as the “25/5/50 rule” or "50% diversification rule").

With mega-cap stocks like Apple, Microsoft, and Nvidia continuing to rise and take up larger portions of index funds, some ETFs and mutual funds could be forced to trim their holdings to stay within these limits. If and when this happens, it could lead to a wave of forced selling, adding unexpected selling pressure to these highly concentrated names.

Has This Happened Before? 

A recent example of this risk occurred in 2024 when surging valuations of major tech stocks pushed their weightings in major index funds beyond regulatory thresholds. As a result, large investment firms, including Fidelity and T. Rowe Price, were required to sell portions of these stocks to comply with IRS diversification rules. Similarly, S&P Dow Jones Indices revised its sector index methodologies to prevent excessive concentration, capping the total allocation of large companies at 45%. These regulatory-driven sales highlight how index funds managing hundreds of billions of dollars may be forced to rebalance, potentially leading to extreme downward pressure on the largest stocks when valuations become overstretched.

Why This Matters for Investors

Index concentration is at record highs, with the largest companies making up an outsized portion of the S&P 500. This means more investor dollars are tied to fewer stocks, increasing vulnerability to market shifts. If selling pressure rises due to index funds rebalancing or regulatory-driven adjustments, these stocks could experience sharper declines than many expect. Additionally, with forward P/E ratios already stretched, any sudden liquidity shift could magnify volatility, especially for companies benefiting from passive fund inflows. These factors highlight the importance of understanding structural risks within index investing and the potential impact of forced selling in a downturn.

A Smarter Approach to Long-Term Investing

The core of our investment offering utilizes funds from Dimensional Fund Advisors (DFA), which don't adhere to a strict indexing approach. You can learn more about how DFA's investment approach differs from indexing in this YouTube video. Rather than concentrating portfolios in the market's biggest stocks at elevated valuations, we prioritize diversification across companies of all sizes, with a tilt toward historically rewarded factors like small-cap value and high-profitability stocks. This approach seeks to reduce concentration risk while maintaining exposure to long-term market growth. 

If you're concerned about how your portfolio is positioned in today's concentrated market environment, let’s discuss how a more balanced, evidence-based approach can help manage risk while still capturing long-term growth opportunities.