Two bold funds riding the popular wave

Since early 2023, global markets have been enthralled by all things artificial intelligence (AI) related, and with it, the emergence of the so-called Magnificent Seven and their stratospheric gains.

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As a result, these AI mega-cap names have increased their share of the index as seen by concentration in the S&P 500’s top holdings from 25% in January 2023 to 34% in July 2024. This is significant given that the US makes up circa two-thirds of the global market by market capitalisation.

Narrow market leadership, however, has been a feature in numerous equity markets across the world with top names in Asia and the emerging markets accounting for even higher share of returns in their respective indices, albeit rather muted compared to the immense returns of the Magnificent Seven.

So, what do investors need to be aware of? For one, investors need to recognise the outsized influence on the overall direction of the market by the heavyweights of the index, which poses a risk to diversification.

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Market leadership is not necessarily stable over time and high levels of concentration can unwind quickly if fundamentals and the outlook for these mega-cap names no longer justify the hefty valuations or meet lofty investor expectations.

From a fund perspective, active funds have tended to underperform top-heavy indices in times gone by due to insufficient exposure to the large constituents, as any fund manager who did not hold the likes of Novo Nordisk AS ADR (NYSE:NVO) or NVIDIA Corp (NASDAQ:NVDA) will tell you. This could be due to regulatory constraints on stock level concentration, or a fund manager’s desire to differentiate their offerings from the index in an attempt to generate alpha.

Although generally underexposed to the top index names, numerous Morningstar Categories (fund sectors) have shown consistently higher and rising concentrations versus market indices. In Europe, Morningstar Manager Research found that average fund concentration in top five fund holdings has been consistently higher than the index, but funds have also increased their exposure to the top five index holdings in the Europe Large-Cap Blend and Growth categories.

What this indicates is that although fund managers have always been happy to express their conviction through concentrated bets in stocks with lower market-caps, managers have had to increase exposure to the largest index names as it is becoming increasingly challenging to generate alpha when underexposed to the mega-cap stocks that make mammoth gains in periods of increasingly narrow market leadership.

Given fund concentration has overall trended upwards in recent years, does concentration matter for performance? Obviously, concentration alone is not a barometer for relative performance as funds need to be concentrated in the right stocks, however, our research observed that European equity funds with higher concentrations have generally performed better in the Europe Large-Cap Blend and Growth Morningstar Categories.

Recent history also suggests that in periods of narrow market leadership, letting your winners run and maintaining some level of concentration and closeness to the index is necessary to land in the top performance quartile.

Funds that take concentrated bets  

Looking at the ii Super 60 list of funds, GQG Partners Global Equity is a good example of a fund that backs itself to take big, concentrated bets. The fund is managed by Rajiv Jain, who established GQG Partners in 2016 after a long and successful career at Vontobel where he managed both global and emerging market equity strategies, Brian Kersmanc and Sudarshan Murthy. 

The managers have a growth-orientated outlook and in seeking to achieve this they adopt a flexible, medium-term investment approach and consider limiting losses a priority. As a result, they look for companies that are on a solid financial footing, have weathered tough economic times and whose industries are growing rather than stagnating.

The key differentiator for this strategy is that it can, and will, change direction in dramatic fashion, unlike its rivals. In 2020, the portfolio held no exposure to energy, but this had increased to almost 30% by mid-2022. Exposure in tech, a mainstay for most growth funds, fell from over 30% in 2020 to 5% in March 2022, on the basis that valuations were too high to make sense, before the team pivoted back into the sector heavily in early 2023; just as AI exploded on to the scene.

Although Jain is willing to go against the pack, he's also willing to ride the popular wave if analysis proves it to be prudent with numerous big names of recent times featuring heavily in the top holdings of the portfolio such as Novo Nordisk, Eli Lilly and Co (NYSE:LLY), Meta Platforms Inc Class A (NASDAQ:META) and Nvidia.

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Moving on to the ii ACE 40 list of sustainable funds, the M&G European Sustain Paris Aligned fund has consistently taken concentrated bets within its top holdings and has been rewarded for doing so. The fund holds, and is overweight, five of the top 10 holdings in the MSCI Europe ex-UK (Novo Nordisk, Schneider Electric SE (EURONEXT:SU), SAP SE (XETRA:SAP), Nestle SA (SIX:NESN) and Siemens AG (XETRA:SIE)), on top of taking bets on stocks with smaller market caps within the fund’s top 10 holdings.

John William Olsen has managed this fund since 2014 and the approach is to know a small number of companies extremely well. This is supported by fundamental analysis and company engagement with a focus on finding companies with sustainable competitive advantages that should lead to pricing power and superior returns over the long term, in addition to meaningfully reducing their carbon intensity. The portfolio is required to have a weighted carbon intensity at least 50% lower than the benchmark.

Brian Hui is an investment analyst at Morningstar.