SPY Or XMAG And MAGS? The Case For Splitting The Index (NYSEARCA:SPY)

The article highlights that the SPDR S&P 500 ETF (SPY) provides less diversification than commonly perceived due to its substantial market-cap weighting towards a handful of 'Mag 7' companies. It proposes a strategy for institutional investors to manage this concentration by utilizing separate ETFs, XMAG (S&P 500 ex-Mag 7) and MAGS (Mag 7), allowing for tailored portfolio allocations. While this approach offers flexibility and can amplify returns when the Mag 7 outperform, it also magnifies risk and incurs higher fees, requiring outperformance to justify the added cost, making the optimal allocation dependent on individual risk tolerance and market outlook.

Analysis

The SPDR S&P 500 ETF (SPY) presents a significant concentration risk, contrary to the common perception of it offering broad market diversification. Its market-cap weighting structure results in a heavy allocation to the 'Magnificent Seven' stocks, making the index's performance highly dependent on this small cohort. An alternative strategy involves unbundling this exposure by using the Defiance Large Cap ex-Mag 7 ETF (XMAG) and the Roundhill Magnificent Seven ETF (MAGS). This approach grants investors granular control over their allocation to the Mag 7 versus the remaining S&P 500 constituents. While backtesting suggests that overweighting MAGS can amplify returns when mega-cap tech outperforms, this flexibility comes with magnified risk and volatility. Furthermore, the combined XMAG/MAGS strategy carries higher fees than SPY, necessitating outperformance to justify the additional cost. The optimal allocation is therefore not static but depends on an investor's risk tolerance and forward-looking thesis on the Mag 7's performance relative to the broader market.

Key Decisions for Investors

• Investors holding SPY for diversification should re-evaluate their portfolio's concentration in the Mag 7 to ensure it aligns with their risk tolerance.
• Tactical asset allocators can use a combination of XMAG and MAGS to express a specific view on mega-cap leadership, allowing for overweight or underweight positions relative to the S&P 500 benchmark.
• Before adopting the split-ETF strategy, investors must consider the higher combined expense ratios, which create a performance hurdle that must be overcome to justify its use over the more cost-effective SPY.
• Given that this strategy increases tracking error and magnifies both gains and losses, it is most suitable for investors with a higher risk appetite and a strong conviction about the future performance of the Mag 7.