The equity market is concentrated – but does it matter?

In the first part of this blog we explored how market concentration can be measured and concluded that the US market does show signs of concentration, largely due to the ‘Magnificent 7’ stocks [1].

The obvious question now is: Does this pose a threat to investors? We can view this question from three different perspectives – performance, risk and fundamentals.

Performance

As the composition of the top 10 stocks has varied in market-cap indices over time, we have assessed the contribution of these stocks to performance across various market conditions. The table below illustrates the average total performance for each portfolio across different market scenarios.

Historically, we observe that during stressed and sideway market conditions the performance of the top 10 stocks is very close to the performance of the market portfolio, the equally weighted market portfolio and the market portfolio excluding the top 10 stocks, highlighting the broader alignment of the various portfolios to the market.

We also observed that the top 10 stocks portfolio has outperformed the market, the equal-weighted market portfolio and ‘model market portfolio excluding the top 10 stocks’ over periods of growth, which reflects the specific nature of this outperformance. Any investor not holding the top 10 stocks at all would have missed out on the excess performance.

However, given the multiple periods considered, the equal-weighted portfolio with lower-than-market exposure to these top names could perform on par with the market on average, in the periods considered.

Risk

Considering the historical beta and risk contribution of the market-cap weighted Mag 7 and non-Mag 7 portfolios against the global market during January 2019 to May 2024, the beta of the Mag 7 portfolio is very close to 1, which means that the Mag 7 portfolio is aligned with the market moves, in a similar fashion to the non-Mag 7 one.

However, regarding the Mag 7 contribution to the performance of the global market, the results are dramatically different. Below we show the performance of the Mag 7 and non-Mag 7 versus the global market (Stoxx World AC Large and Mid Cap Index) over the same period. Not holding the Mag 7 stocks results in a performance lag of 2.5% on an annualised basis with respect to the market from January 2019 to May 2024, despite having similar risk characteristics to the market.

Fundamentals

A high level of concentration in US stocks is often seen as a significant risk, mainly due to increasingly higher valuations in the concentrated stocks, prompting concerns that these levels may be unsustainable.

Comparisons are often drawn to the Dotcom Bubble. Though there are parallels, key differences exist, particularly when it comes to valuation metrics. Below we compare the sector average for the price-to-earnings (P/E) ratio and return on equity (ROE) of the North American technology sector, as at March 2000 and June 2024. Although valuation levels are currently elevated, the level is three times lower today than that observed in 2000. Moreover, the sector also seems to be more profitable than it was 20 years ago.

Where should investors go from here?

We have observed that the Mag 7 is a source of concentration in global benchmarks but has been rewarded over time. Nonetheless, we did find that concentration risks are prevalent and significant in country, region and global indices. Therefore, it may be prudent for investors to consider diversifying country and stock-specific risks*.

Today global benchmarks reflect a mixture of both momentum and quality style biases. For example, the Mag 7 companies are profitable and have seen strong momentum in stock price performance for several years. One approach to managing concentration risk is to target a balanced factor exposure. We believe this could help manage stock-specific risks and rewards in systematic strategies over time.

In either case, we believe investors could limit their exposure to concentration risk by imposing caps within their portfolio construction methodologies. This approach can help manage the exposure to specific or group of stocks that may drive a disproportionate share of benchmark returns, thereby managing extreme idiosyncratic events. By controlling for such concentrations, investors may be able to reduce the potential impact of market reversals and build a more resilient, balanced index and systematic strategies that potentially are less vulnerable to the volatility of individual stocks.

 

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

 
[1] Comprising Microsoft*, Apple*, Amazon*, Alphabet*, Meta*, Nvidia* and Tesla*. Hereafter referred to as ‘Mag 7’.