How does index concentration impact investors?
There is a lot of concern in the financial world about concentration in the US market, particularly around the ‘Magnificent Seven’ stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla). We certainly believe this needs to be monitored, but it shouldn’t be something that keeps investors up at night – indeed it is commonplace. We also explain why market concentration is a headache for fund managers, and why it attracts so much commentary.
The chart below shows how the top 10 stocks in the US have risen to make up about 38% of the S&P 500 index. This is higher than in recent history, but in line with the early 1960s when the top 10, mainly the big auto stocks, made up 40% of the index. We all know that we should diversify so a reasonable question for investors to ask is: does this increased concentration add to risk?
In financial markets it is always rash to be emphatic, but it seems that the increased concentration in markets has not led to increased risk. Investment house AQR tested this by looking at the “concentrating” S&P 500 index and then looked at the S&P 500 equally weighted index, made up of the same 500 companies but where each company had the 0.02% weight and has no concentration by design. Their result is shown in the chart below.
Where the purple line goes up it means that the S&P 500 risk is increasing relative to the S&500 equal-weight index, and vice versa. If the concentration of the market was leading to an increase in risk this would be apparent in the purple line rising since 2015. There has, however, been no marked increase since 2015. The purple line is broadly steady since 1975, except during the late 1990s during the dot.com boom and bust.
It would be a concern if the biggest stocks in the S&P 500 were all in the same business or exposed to some unique common factor that drove only their share prices. Unlike the autos of the 1960s, that does not seem to be the case today. While the ‘Mag 7’ can all loosely be described as tech, they all operate in different areas of the market and only marginally overlap.
There are regulatory challenges that some of the companies face which could force their break-up, but that does not necessarily add to or detract from risk. We saw this in 1984 when AT&T was the biggest stock in the US. It was ordered by the government to break-up overnight into seven regional “Baby Bell” companies. This break-up reduced concentration but did not change risk.
Concentration in markets is nothing new. The top 10 stocks in the US make up about 40% of the index, but in the FTSE 100 it is 47%. Compared to some indexes, the S&P 500 and the FTSE 100 are unusually well diversified. In 2000 Nokia made up 70% of the Helsinki OMX index, compared to just 10% today, and in 2008 Volkswagen made up 27% of the DAX 40 index – it is now a paltry 1.2%.
Very concentrated index funds focused on one stock, or one undiversified group of stocks, add risk for investors. That is why you often see Exchange-Traded Funds that follow “capped” indexes; the Polish ETF follows a 25/50 index, meaning no one stock can be greater than 25% of the index and the top five stocks cannot total more than 50% of the index. However, even these rules, designed to enforce diversification, can still leave some ETFs quite concentrated and risky.
The success of weight loss drugs has led the Danish stock market to concentrate around pharmaceutical firm Novo Nordisk. Novo is now 54% of the MSCI Denmark index which is why the ETF following the MSCI Denmark 25/50 index limits the exposure of Novo to “just” 20%.
Another topical sector is European Aerospace and Defence. The main index in this area is the very concentrated MSCI index, where the top five companies make up 80% of the index. Such a concentrated ETF would never get regulatory approval. Consequently, the European Defence ETFs follow bespoke indexes by capping stocks and squeezing them into something that can be sold.
If we believe that the apparent concentration in the US market is nothing to worry about, why does it prompt so much commentary? The answer is possibly due to the way active fund managers invest. They generally run concentrated funds of 30-50 stocks, and must back a select group of stocks. They tend to ignore the very largest stocks and back smaller, faster growing companies. This means they tend underperform when the largest stocks are also the best performers.
Backing smaller companies is usually a safe strategy for active fund managers, but the last two years it has been a losing strategy. As the chart below shows, the key drivers of the S&P 500’s return in 2023 and 2024 have been the Mag 7 stocks.
Mag-7: Percent Contributions to the S&P 500 Return
Source: AQR
If fund managers want to keep their jobs, it has become a binary question of owning the Mag-7 stocks or not. As long-term investors in funds, we must be patient with fund managers who have underperformed in this environment and stick with those managers where underperformance is transitory.
Market concentration has increased in the US, but we do not think it should cause investors any concern as the S&P 500 remains a well-diversified index compared to other indexes. History has shown us that the US is also the home of capitalist innovation and while we cannot predict the future, experience tells us that new opportunities and new companies will emerge to take leadership positions in the US stock market.
Simply pouring out money into ETFs often means that we are pouring our savings into the established players and older companies on the market and not the small fast-growing companies of the future. With patience and skill, we back our active managers to pick the Mag-7 stock of the future and deliver market-beating returns.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
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