Threading the needle: finding balance in a concentrated investment world

Global equity benchmark holders have enjoyed a market rally after a difficult 2022, at least until this summer. Between mid-October 2022 and the end of July 2023, a typical US equity index delivered a return comfortably above 25%.¹

Behind the strong headline number, however, lies an increasing performance contribution from a comparatively small number of companies. This poses concentration risk not only for investors who hold US index exposure, but also for holders of global equity indices with common underlying exposure.

A typical broad global equity benchmark has around two-thirds of its stocks domiciled in the US.² Perhaps unsurprisingly, global equity indices therefore share the majority of their top 10 constituents with US equity indices, and the typical overall portfolio overlap between the two is currently over 60%.³

Given the prominence of these mainstay indices in investors’ portfolios, it is interesting to analyse how they have evolved over time. In this blog, we will also touch on how investors might look to diversify,⁴ to potentially mitigate rising concentration risks.

How did broad indices become so concentrated?

Market concentration has increased over the past decade. Comparing the sector breakdown of the US market today versus 2009, the key difference is the IT sector. It used to make up around 15% of the index, but today that has risen to around 27%.⁵

Comparing the index’s top five holdings in 2009 versus today, they share only one name – Microsoft – and the concentration in top holdings has also increased from 10% to over 25% today.

This has resulted in recent positive US equity index performance being driven by a relatively small number of stocks, namely the ‘Magnificent 7’ of Apple*, Amazon*, Alphabet*, Meta*, Microsoft*, Nvidia* and Tesla*.

Index investors often choose indices over actively designed approaches to gain exposure to broad market risk rather risks associated with specific companies. Yet today, many may be unaware how much of their returns could be dependent upon the mega-caps and how much company-specific risk they actually hold.

In the event of severe drawdowns specifically affecting those companies, it will directly feed into the different indices with high allocation to those names.  

What can we do about it?

When global equity indices may increasingly look like a material bet on mega-cap tech companies becoming even larger, what can investors do to manage that risk?

They could always move back to active management, where the manager might lower exposure to the ‘Magnificent 7’ and offer exposure to other themes that they believe provide more attractive risk-adjusted return potential.

However, this may introduce other types of stock-specific risk given the active nature of the approach and may potentially increase costs. If they would like to preserve the simplicity and transparency of the index approach, they essentially have three options:

1. Use regional equity indices to build a more balanced equity portfolio, spreading the risk across key geographical regions such as Europe, North America, Japan, the rest of Asia-Pacific and emerging markets. This preserves the transparency of the market-cap weighted index approach, but lowers reliance on US stocks and in particular US mega-cap tech.
2. Complement their market-cap exposure with a single- or multi-factor equity index exposure, which will tilt their exposure towards equity factors that have been shown to reward investors with long-term premia such as value, low volatility, quality, size or momentum.
3. Replace or complement market-cap exposure with equal-weighted investments leveraging emerging areas shaping our future. Thematic investing is increasingly capturing investors’ attention as it provides exposure to global long-term growth industries with very low overlap with existing benchmarks. When identified and designed carefully, thematic portfolios can act as a diversifier, while providing access to important areas such as clean energy, access to clean water and cyber defence.

Index investment is on the rise, and recently hit the milestone of accounting for more than half of global equity assets. In our view, this long-established trend is unlikely to reverse anytime soon.

With indexed US and global equity allocations a mainstay of most portfolios, we believe it’s logical to examine the sources of risk and return within these indices, and to consider strategies that tackle rising concentration risks and improve diversification.

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

1. The S&P 500, for instance, rose 28.3% over this period. Source: Bloomberg data covering 12 October 2022 to 31/07/2023

2. The MSCI World, for instance, has a 69.7% allocation to US stocks. Source: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb

3. Nine of the top 10 portfolio holdings are the same in the S&P 500 and the MSCI World, and the overall portfolio overlap is around 66%. Source: Bloomberg data using ETFs as a proxy of index compositions, as of 02 October 2023

4. It should be noted that diversification is no guarantee against a loss in a declining market.

5. Statistics for S&P 500 index. Source: Bloomberg data using ETFs as a proxy of index compositions, as of 02 October 2023