🎙️ Ponzi Funds

The S&P 500 is up 15% year-to-date, minting 31 new all-time highs. Earlier today, it briefly crossed 5,500 for the very first time.

Yet only 17% of its stocks have outperformed the index over the past month — the worst divergence in over a decade, making it harder for stock-pickers to outperform.

That further highlights the uneven nature of the market's gains, concentrated in a few large tech stocks carrying the load. It’s what the market technicians call “narrow leadership.” More insight below on market concentration and why it matters.

Also: In case you didn’t notice, we were off yesterday for the Juneteenth Holiday (markets were closed, too). We’re here today to recap the biggest stories of the past few days. Our regular schedule will resume tomorrow.

— Matthew & Shawn

Here’s today’s rundown:

Today, we'll discuss the biggest stories in markets:

• The curse of self-inflated returns

• 200 years of market concentration

This, and more, in just 5 minutes to read.

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In The News

🔥 Hot Funds and the Curse of Self-Inflated Returns

Buyer beware: The dangers of hot money in ETFs can create major losses to investors’ portfolios. A new study cautions investors to carefully consider such “Ponzi Funds.”

When an exchange-traded fund (ETF) starts generating high returns, it might attract new investors chasing hot performance. But this "hot money" influx can drive the fund's future returns in a self-reinforcing cycle - creating what researchers call "self-inflated returns." Eventually, this cycle is bound to reverse, leaving investors with losses.

How it happens: The process starts when an ETF, whether actively managed or simply tracking a narrow market segment, produces outstanding performance. That draws attention from investors looking to capitalize on the fund's success. 

• As they pour millions or billions of dollars in, the ETF's managers must invest that new cash into the same securities the fund already holds.
  

• If the holdings are smaller, thinly traded stocks, the ETF's buying power can still drive their prices higher. That further inflates the fund's returns, attracting even more hot money inflows in a self-perpetuating cycle. Investors are essentially "chasing their impact" on the stocks.

Case study: Just ask the folks at Ark, which has cratered from its early 2021 peak. The Ark Innovation fund, led by Cathie Wood, earned one of the highest returns in history when it ran up 153% in 2020. 

• But in late 2019, the WSJ reported that ARK Innovation had nearly 25% of its $1.6 billion in assets in only nine stocks. It owned over 5% of the total shares at each of them.
  

• In 2020, Ark’s assets grew more than ninefold from $1.9 billion to $17.7 billion. Its assets peaked at about $25.5 billion in mid-2021. They’ve since dwindled to $6.3 billion, and the fund has lost an average of 27.9% annually over the past three years. 

Why it matters:

It’s a raging bull, and many investors are trying to keep the hot returns strong. 

While this self-reinforcing pattern can persist for some time, misleading investors about the true source of the fund's returns, it is ultimately unsustainable. Sooner or later, performance often falters, triggering a reversal as the hot money rushes back out. Fund managers are forced to sell, pushing stock prices down and worsening losses. Not pretty. 

The Wall Street Journal’s Jason Zweig highlights the issue in a recent column while pointing out a few things to keep in mind when seeking hot ETFs:

• Beware of concentrated holdings: Funds that hold just a few dozen stocks, especially smaller companies, are prime candidates for hot money distortions.
  

• Check for caps on holdings: Some ETFs limit their largest positions to a fixed percentage of assets to prevent over-concentration.
  

• Watch for high short interest: If a fund's top holdings are heavily shorted, it could signal an inflated price.
  

• Avoid rapid asset growth: When billions rapidly flow into a small, successful fund, be wary of self-inflating returns. As Zweig warns, “When billions of dollars gush into a small fund that just reported big gains, self-inflated returns are likely to follow. Let other people chase them. In the end, all they’re likely to end up with is self-deflated returns.”

Bottom line: The allure of a hot performer is always there, but chasing those returns often ends in disappointment as the cycle reverses. Historically, sticking to broader, diverse funds has helped investors avoid self-inflated gains that inevitably deflate.

Read more about ‘Ponzi Funds’

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📊 200 Years of Market Concentration

So much for diversification — today’s market is heavily concentrated, and the trend has been investors’ best friend. 

Over the past decade, the largest companies in the U.S. stock market, known as the "super-caps" like Apple, Microsoft, Alphabet, Nvidia, Amazon, and Meta, have grown faster than mid and small-cap firms. As a result, the top 10 stocks have doubled their share of the S&P 500 index.

Supercycle: The super-caps, now trillion-dollar companies, are better positioned than smaller rivals to capitalize on new technological innovations in IT, biotech, and other sectors. They can also acquire promising startups before they go public, further solidifying their dominance and keeping the cycle going. 

• The U.S. stock market has become more concentrated, outperforming global markets. Currently, 21 of the top 25 companies worldwide are American.

A historical view

The trend is not an anomaly but part of a recurring pattern over the past 235 years where the market alternates between periods of higher and lower concentration. That’s according to a fascinating historical analysis from Bryan Taylor, an economist. 

1790-1840: The Bank of the U.S. dominates

• The First and Second Banks of the United States were the largest corporations until the 1830s, when railroads reduced finance's dominance. Until the 1830s, finance stocks made up over 90% of the total market cap of the U.S., a kind of concentration that we might never see again. 

1840-1875: The rise of railroads

• Railroads and related industries like Western Union and American Express dominated the market until the 1870s.

1875-1929: The American commercial revolution

• New sectors like utilities, consumer goods, autos, and radio flourished, decreasing concentration until the 1929 crash and Great Depression. 

1929-1964: The first "Magnificent Seven"

• AT&T, GM, IBM, Standard Oil, GE, DuPont, and U.S. Steel dominated in a relatively stable period with little change. Taylor writes, “The 1960s was the era of the ‘Nifty Fifty’ when supposedly, you could put your money in any of the top fifty stocks and go on vacation.”

1964-1993: Free trade and global expansion

• Rapid innovation in tech, healthcare, and services led to increased diversification, hitting a low in 1993.

1993-2014: Rise and fall of concentration

• The internet drove concentration peaking in 2001 before falling back to 16% in 2014, a new low.

2014-Present: Tech dominance

• Since 2014, the share of the top 10 stocks doubled to 32.5% in 2024, led by trillion-dollar tech giants.

Why does tech’s rise = concentration? Tech firms have contributed to increased concentration because their services are ubiquitous, they stay ahead of the competition thanks to their massive resources, and their sheer size and strength can make it very difficult for startups to compete and disrupt their business models. 

Broadly, the rise of mobile computing, social media, online advertising, cloud services, etc., has allowed Big Tech to expand into multiple technology verticals, further establishing dominance.

Why it matters:

Historically, increased concentration has signaled bull markets, while bear markets have reduced it. But the dramatic rise since 2014 suggests the trend may be greater concentration for years (or decades), thanks to AI and technological innovation favoring the super-caps.

• Taylor’s analysis concludes: “In the past, sudden increases in market concentration were not followed by dramatic bear markets. Bull markets continued for years following the concentration associated with a bull market's onset.”

Read more

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Quick Poll

On Monday, we asked: Are you invested in Microsoft stock? Why or why not?

— Most readers who own Microsoft touted its progress in AI, “wide moat,” and good leadership. “One's never too late with great companies as long as valuation ‘makes some sense’...but sure hope I had acted sooner!” one person said. Another: “Invested at $40/share and it was undervalued then; hanging on for the ride. Portfolio holder for life, most likely. Buffett’s 20 on the punch card!”

— People who are less bullish said things like, “I just don't see the moat or the brand loyalty. People use Microsoft partly because they have to, not because they necessarily want to--or it's "cool." And AI is moving so fast OpenAI could be irrelevant tomorrow.”

See you next time!

That's it for today on We Study Markets!

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