Market cap weighted passive funds have done a great job for investors since the 2008-9 Global Financial Crisis (GFC). Their simplicity, low cost and ability to capture prevailing market momentum has been a winning formula for investors, especially in the US.
But passive investing is not risk free. Growing regional, sector and stock concentration has seen diversification decline and an increase in the potential for spikes in volatility.
Sixteen years after the GFC, US passive funds – like mutual funds and ETFs - now make up 50% of the market. This accelerating trend drives more money into market cap weighted indices, which often causes the largest companies to grow even larger in a perpetual loop. As advocates of diversification, this growing market concentration is something that makes us increasingly wary of.
Source: Morningstar and T. Rowe Price, Dec 2023
Valuation distortion
A core principle for successful long-term investing is being disciplined around valuations – where your starting valuation often determines your future returns. The challenge with passive investing is that valuation isn’t the driving force; it’s just an outcome of the portfolio.
Currently, this means that US passive funds, like those tracking the S&P 500, are quite pricey. The S&P 500 trades at 22 times forward earnings, well above its historical average of 17.5. Even more concerning, the largest 10 stocks are trading at an eye watering 29 times earnings.
However, strip out the top 10 stocks and the valuation of the remaining 490 companies is closer to historical averages, indicating there’s still value for active managers to find attractive investment opportunities.
Source: UBS and ClearBridge Investments, August 2024
*NTM (next 12 months)
Following an extended period of outperformance driven by a handful of stocks in just two sectors (it would have been just one sector if S&P had not created the Communications Service sector in 2018), passive investors are now increasingly exposed to a highly concentrated market dominated by the technology sector. At the same time, the tech giants are finding it hard to even meet consensus earnings forecasts, never mind exceed them, which is required to drive share prices higher. The increased concentration risk at a regional, sector and stock level should give us all pause for thought.
Soaring concentration risk
Many investors assume buying into an index brings broad diversification and reduced single-stock specific risk. The reality today, thanks to market concentration, is very different. You just need to look at what happened with Nvidia, the third-largest stock in the S&P 500. Over the summer, its market cap fell in a single day by the equivalent of Starbucks’s entire value or 50% of Tesla! This increased concentration means passive investors are facing a higher chance of greater volatility due to greater single-stock exposure.
Markets don’t stand still
Markets move in cycles, and periods of increased concentration are nothing new. What’s different this time is the degree of concentration in the S&P 500. Historically, the largest sector weight has represented less than 20% of the index, whereas today it’s 32% - add in Communication Services to Technology and it’s nearer 40%. This is more than two times the size of the next largest sector – something which hasn’t happened since the dot-com bubble of 1999. Back then, within a year of hitting such high concentration, the sector’s weight collapsed to less than 20% of the index.
Source: Factset and ClearBridge Investments, 30 June 2024
Today, the tech sector has strong fundamentals, supported by solid earnings and cashflows, which lends credibility to its valuation premium, suggesting greater scope for resilience and sustainability. However, the benefits of AI are expected to spread beyond US tech into other global industries, indicating a growing probability that the valuation differential will narrow and converge over time.
Change is inevitable
The past is never a guarantee of the future, but it can help to keep us grounded in our analysis and tuned in to how things might unfold.
Sector leadership is dynamic, as history has shown time and time again. Is the current US market and technology sector leadership susceptible to change? Absolutely, but it will require either the rate of growth of earnings from other regions and sectors to match or better those of the US, or investors to taper their enthusiasm for the US, to hamper willingness to pay a valuation premium.
Momentum is a powerful driver of capital markets, with investor sentiment often leading to overbought and oversold situations. But trends don’t last forever. We need to stay disciplined and maintain healthy diversification, combining low correlated asset classes and avoiding unwanted concentration risk.
Our Risk Graded portfolios are designed to withstand these changes, with a focus on delivering consistent, risk-adjusted returns over time. While this approach may mean we fall behind during periods where a single country, sector or style dominates, much like the tortoise and the hare we expect our diversified approach to win over the full course of the race.
We’re in a period of impending change with large cap leadership slipping, US dominance easing and growth style moderating. We don’t have a crystal ball, but we are prepared and excited at the prospects that lie ahead. Confidence comes from the knowledge that our disciplined, diversified, risk-focused approach will guide us through.
Source: S&P, Russell, UBS, Bloomberg and ClearBridge Investments, July 2024
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.