Magnificent Seven Drive 2023 U.S. Large Caps – And Spotlight Index Profitability Rules

By Catherine Yoshimoto, Director, Product Management

After a sharp downturn in 2022, large cap equities bounced back to deliver strong performance in 2023. The Russell 1000 Index posted a 26.5% return for the year, largely buoyed by the Magnificent Seven. However, several other constituents were contributors to strong 2023 index performance—and these companies wouldn’t have been included in the index if our methodology required a consistent track record of profitability.

Methodology for the modern mega cap

The Magnificent Seven’s dominance represents a paradigm shift in the type of companies that grow to become mega caps. While the largest US companies by market cap used to be older, stalwart companies that had been household names for generations, the biggest mega caps are now more modern companies widely known for new technology and innovation. This suggests investors have shifted from a backward-looking profitability analysis to more of a forward-looking approach, perhaps with the belief that technology and innovation have the potential to drive company growth.

This trend raises questions when it comes to index design. Russell Indexes—like all indexes—are a product of their inclusion methodology. We use a rigorous and transparent methodology to construct them, where companies are required to meet a robust set of criteria for inclusion. And while these criteria are designed to screen companies for eligibility based on characteristics such as minimum voting rights, investability, and liquidity, they don’t include backward-looking profitability requirements. As such, many companies have been added to our indexes just as they’re beginning to grow—at times making a material difference in index performance.

No history of profitability? No problem.

Several Russell 1000 constituents proved they didn’t need a history of profitability to deliver strong returns in 2023. As shown, some of last year’s top performing Russell 1000 companies didn’t report four consecutive quarters of profitability—but were nonetheless included in the index and outperformed the broader index by a wide margin.

Russell 1000 Constituents: Strong 2023 Performers Without a History of Profitability

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Source: FTSE Russell. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

The Magnificent Seven illustrate the cost of profitability requirements

We need look no further than the Magnificent Seven companies for the ultimate proof that a long-term record of financial stability is no longer required to rise to the ranks of the largest US equities. As shown below, we added several Magnificent Seven companies to the Russell 3000 Index shortly after their IPOs—and it subsequently took years for these companies to become profitable for four consecutive quarters.

Time Between Russell Index Eligibility and Company Profitability

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Source: FTSE Russell. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

If we’d waited until these companies had reported four consecutive quarters of profitability, there would have been considerable opportunity cost in Russell Index performance. As shown below, all of these names grew significantly in the intervening period between inclusion in the Russell indexes and profitability.

Cumulative Total Return Between Russell Index Inclusion and Company Profitability

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Source: FTSE Russell. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

What it means to be an index

An index is only useful to the extent that it accurately reflects the market it’s designed to represent. Before the rise of the Magnificent Seven, it was uncommon for Technology companies with relatively short histories to be counted among the largest US stocks. But the investment landscape has evolved such that a company’s journey from IPO to mega cap can outpace its path to profitability. And if profitability requirements mean these companies are overlooked when it comes to equity index inclusion, then the index becomes a less accurate reflection of the market—and the potential impact on performance can be meaningful.

Disclaimer

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