Your Large-Cap Fund Might Be Sitting on a Microsoft Bomb

by Daniel Putnam | July 23, 2013 6:00 am

If the number $34 billion doesn’t mean anything to you, it should — that’s how much value was wiped out of Microsoft’s (MSFT[1]) market capitalization last Friday, when the stock was knocked for a loss of more than 11% following an earnings miss.

The impact of this move extends far beyond Microsoft itself, as mutual fund investors will see when their third-quarter statements arrive in early October. If Friday’s losses mostly hold (MSFT did recover 2% by the end of Monday trading), a fund’s position in Microsoft — overweight or underweight — is likely to represent the key driver of its third-quarter performance.

msft Your Large Cap Fund Might Be Sitting on a Microsoft Bomb[2]

The reason why is that Microsoft represents such a large component of the major benchmarks. Coming into this quarter, the stock was a top-five holding in the S&P 500, Russell 1000 and Russell 1000 Growth indices, not to mention the Nasdaq-100 and virtually all technology-related indices.

As a result, a huge swath of the U.S. mutual fund universe is benchmarked to indices in which Microsoft carries a heavy weighting — meaning a fund’s position in the stock is going to have a major impact on its relative performance.

Consider this: Say, for example, Microsoft makes up a 4% weighting in a given benchmark and — for the sake of argument — it finishes the quarter with a loss of 15%. Fund 1 has a 2-percentage-point overweight in the stock (a 6% weighting), while Fund 2 holds a 2-point underweight (a 2% weighting). At the end of the quarter, Fund 2 will have outperformed Fund 1 by a full 50 basis points (0.6 percentage points).

In a world in which the practice of closet indexing has become the norm rather than the exception, these 60 basis points make a huge difference — and likely will determine whether a fund finishes in the top or bottom third of its peer group for the quarter.

This isn’t the first time a single stock has had such a large impact on index and fund performance. Recall that in the third quarter of last year, a similar phenomenon[3] occurred with Apple (AAPL[4]). If a fund was overweight in the stock, chances are it outperformed in that quarter. Unfortunately, the opposite also was true once Apple shares hit the skids in the final three months of the year.

What fund families are in the crosshairs of the Microsoft downturn?

Among the complexes likely to be impacted are American Funds, Allianz and Dodge & Cox, all of which have favored the stock in their portfolios. Naturally, investors in these fund families already gained a substantial benefit from Microsoft’s strong performance in the second quarter, when it rocketed to a gain of over 21%.

The point, therefore, isn’t that funds were necessarily wrong in holding Microsoft. Instead, the takeaway is that investors need to be alert to just how much a position in a single large-cap stock can move their funds up and down the performance rankings.

And, secondarily, mutual fund investors should be prepared to see Microsoft playing a leading role in third-quarter performance summaries issued by the fund companies — in either a positive or negative light, depending on whether the fund in question was underweight or overweight.

When the pie is worth $34 billion, there are a lot of pieces to go around.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. MSFT:
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  3. similar phenomenon:
  4. AAPL:

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