China tech: a reminder of the concentration conundrum

Over the past decade, we’ve talked at length about the risks posed by the high weightings in some equity indices to a single country, sector and mega-cap stocks. Generally, our focus has been on the high US weighting in global indices, where it’s about 62%.¹ Not only that, but the five largest stocks make up 19% of the US market.²

As an illustration of these risk concentrations, more than 60% of US equity returns³ came from the tech sector in the six months to June 2023.

In investments, the general rule of thumb is that if something can do very well, it can also do very badly.

We still see a large number of portfolios with higher US weightings than we’d like. In fact, since 1980, the US has fallen from 20% of world GDP to 15% on a purchasing power parity-adjusted basis.⁴ This means that the US contributes only around 15% of global GDP on a price-adjusted basis, and only 25% on a nominal basis.⁵ And yet it has increased its weighting in global market indices to an over 60% weighting – a concentration risk that causes us concern.  

We think one reason this doesn’t get more focus is because US equities have put in a strong performance: US equities have outperformed their international counterparts by an average of 8% per annum over the decade to end 2019.⁶

When all’s going well, it’s natural that any given risk might get less attention. In part, that’s because of normalcy bias, which leaves us susceptible to the belief that events in the preceding years are normal and will continue.

Additionally, with over 20 years having passed since the dot-com bubble burst, there are fewer investors able to easily recall times when technology stocks were laggards bringing down the US market. This predisposition to focus on more recent events is known as availability bias.

However, we believe Chinese technology stocks, since 2017, offer a recent real-life example of the risk posed by concentrations in portfolios.

Initial euphoria

In 2017, the US and UK media extolled the virtues of Chinese tech; the sector’s dynamism, growing user base and ability to innovate were all lauded.⁷

In the same period, the Financial Times ran a deep dive into the outperformance of the largest Chinese tech stocks against their US counterparts: “Tencent’s shares, up 43.6% year to date [YTD 01/07/2017] and contributing 25% of the point gains on Hong Kong’s Hang Seng index, have outperformed Facebook’s 31.7% rise.”⁸

This narrative continued from 2017 to 2020, with Chinese tech indices outperforming national and emerging market (EM) peers.⁹

Off the back of these positive returns, the weight of technology stocks rose, and, as a result, Chinese stocks more generally peaked at 42.5% of EM indices.¹⁰

Return reversals

What we’ve seen since is a stark reminder of concentration risk. We don’t think investors need to predict a downturn to justify a move away from the largest countries and sectors. Instead, they simply need to accept any sector can be the best or worst performer in any given year.

Since 2020, Chinese equities and, in particular, technology stocks, have underperformed other EMs by 40% and 53% respectively.¹¹

In this case, the impact on diversified multi-asset investors was diluted by the lower weight to EMs than to some other regions. Nonetheless, it’s an important example of the potential risks posed by US risk concentrations. If the US went through a similar episode, the impact on multi-asset investors could be much larger, in our view.

What it may mean for portfolio construction going forward

In our view, the Chinese technology example illustrated above highlights the need to be aware of any increases in portfolio concentration across markets and sectors and, difficult as it may feel, to continue to trim outperforming investments to target.

Otherwise, we believe that areas that have previously been regarded as engines for growth can just as quickly become a major drag on portfolios.  

Sources

1. US weight in MSCI ACWI, as at 30 June 2023.

2. Russell 3000, as at 30 September 2023, companies: Apple Inc, Microsoft Corp, Amazon.com Inc, Nvidia Corp, Alphabet Inc Class A.

3. Bloomberg, SPX return YTD as at 30 June 2023.

4. IMF World Economic Outlook, 2023.

5. https://www.theglobaleconomy.com/rankings/gdp_share/

6. Vanguard A tale of two decades for U.S. and non-U.S. equity: Past is rarely prologue, December 2023

7. See, for example, https://www.nytimes.com/2016/08/03/technology/china-mobile-tech-innovation-silicon-valley.html

8. https://www.ft.com/content/d5397a08-4667-11e7-8d27-59b4dd6296b8

9. Source, Bloomberg NCL9000X INDEX, M1CN INDEX, M1CXBRVR INDEX

10. MSCI Emerging Markets, 2016-2023.

11. Bloomberg NCL9000X INDEX, M1CN INDEX, M1CXBRVR INDEX