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Beware of big gains in big names like Apple and Amazon

Tim Cook, CEO of Apple Inc.
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Tim Cook, CEO of Apple Inc.

Since the last rebalancing of the Nasdaq 100 index (QQQ) in 2011, stellar gains among a handful of index constituents have resulted in handsome returns for the overall index as well as very heavy concentrations within the index.

The relative performance of this handful of names has been rather pronounced this year. In fact, the five largest weightings in the index, the "Fast Five" — Apple, Alphabet, Microsoft, Amazon, and Facebook — have increased an average of 22 percent this year, and they now comprise nearly 42 percent of the entire Nasdaq-100!

Given the massive size of these companies, significant price movements by any one of these names could have an even greater impact on overall index returns in the future. Investors using passive strategies, the ranks of which have swelled in recent years, should take heed. You may not own what you think you own.

Again, there is no doubt that returns have been exceptional in recent years for investors in passively managed exchange-traded funds (ETF's) like those that track the Nasdaq-100. The index has nearly doubled over the past five years while rising well over 400 percent since the financial-crisis low in March 2009.

Active portfolio managers have struggled to keep up with this strong performance, if for no other reason than their restrictions on individual stock concentrations. But therein lies the point: The exceptional returns of ETF's that track indices like the Nasdaq-100 were made possible, in no small part, by the strength of the behemoths in the chart above. With such a heavy dependence on the performance of only a few stocks, the risk to that portfolio continues to grow.

When markets do decide to reverse course, many of these investors may not be adequately insulated against the inevitable next market downturn. I suspect this may be the moment when interest in active management returns.

The point may be best demonstrated by looking at the relative performance of the Nasdaq-100 index as compared to a "quasi-passive" ETF called the Direxion Nasdaq-100 Equal-Weighted Index (QQQE, offered by Direxion). The latter holds the same 100 stocks as the QQQ, but it simply holds them in equal weights rather than having Apple make up 12 percent of the index, for example.

The chart below tracks the price movements for each index, beginning with the inception of the QQQE in March 2012, and assigning an initial value of 100 for each index. An untrained eye may believe that the indices had very similar performances, with both increasing around 100 percent from the start date. Upon careful analysis, though, you will see that from late 2012 until the middle of 2015, the blue line (representing the equal-weighted index) was consistently above the orange line (which represents the QQQ with its wide variances in component weightings). The gray bars, which depict the cumulative difference in performance between the two indices, shows that by March 2014, the QQQE had outperformed the QQQ by as much as 8.9 percent. The interpretation? The rise in the Nasdaq 100 index over that time frame was attributable to broad-based strength rather than dramatic out-performance by a few heavily-weighted stocks.

Beginning in March 2014, though, that trend started to reverse. In fact, from March 2014 through today, the QQQ (orange line) has not only erased that 8.9 percent of under-performance, but it has outperformed by an additional 8.3 percent. This means that the QQQ, forty-two percent of which is currently made up of the "Fast Five" discussed above, has crushed the QQQE equal-weighted index by over 17 percent in the past 3+ years. That is quite a reversal, and it is indicative of the dramatic influence of those heavily-weighted "Fast Five" stocks.

Source: PowerShares and Direxion

What can we take from this? Generally speaking, a bull market that is fueled by broad participation among various stocks and industry sectors is considered a healthy sign of investor conviction, whether it is the result of optimism over corporate earnings, strength in the underlying economy, or the efficacy of fiscal or monetary policy (or some combination thereof). A bull market with narrow leadership, on the other hand, can often be interpreted as lacking conviction.

Eight-plus years into a bull market that has seen major market indices rise dramatically, it could be that the indices' heavy dependence on a shrinking number of behemoths is the writing on the wall. At the very least, it makes most sense to know what you own so you can reduce exposure where needed.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.

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