Why concentration risk is a problem for many investors

Much has been written about the way market concentration has increased recently in the US, as a handful of technology-focused businesses have come to dominate the stock market in terms of both size and investor returns.

But what’s going on in other global markets? And what could it mean for investors?

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The so-called Magnificent Seven –  a group of seven US tech giants – now account for over 30% of the S&P 500 index by market capitalization. That market dominance has helped to boost share price gains, as investors have piled in.

Concentration is spreading to other markets

Market concentration is not a new phenomenon, however. For example, says Alan Ray, an investment trust research analyst at Kepler Partners, in the early 2000s Vodafone Group (LSE:VOD) accounted for more than 15% of the UK’s FTSE All-Share index. In fact, he adds, Vodafone “was so large that index tracker funds were prevented by regulation from owning a full weight”.

Tech-driven concentration, however, is not limited to the US. The MSCI Emerging Markets index, for instance, is dominated by Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), with more than 9% of the total index value.

In Europe, as Tom O’Hara, co-manager of Henderson European Trust Ord (LSE:HET), observes, the FTSE Europe ex UK index has seven companies (not all tech) accounting for 20% of market capitalisation, down from 11% a decade or so ago. “So we’re not as concentrated as the S&P 500, for example, but it has become an increasing feature,” says O’Hara.

The global market, unsurprisingly, has been hugely influenced by the trend towards concentration within regional markets, although the US’s dominance, with the country around 70% of the MSCI World Index, means that the leading companies there have most impact.

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In fact, concentration is also much in evidence on our own doorstep. Currently, pharmaceutical giant AstraZeneca (LSE:AZN) accounts for more than 8% of the FTSE All-Share, with the top five stocks – also including Shell (LSE:SHEL), HSBC Holdings (LSE:HSBA), Unilever (LSE:ULVR) and BHP Group Ltd (LSE:BHP) –totaling around 25% of the UK market.

Tech dominance

Why is it happening? Although the UK market is an exception, there’s no doubt that technological innovation, AI and global digitalisation are driving the broader trend to concentration globally this time around.

Craig Baker, head of Alliance Witan Ord (LSE:ALW) investment committee, notes: “It seems clear that over the last decade or so technology companies have found it easier to be successful at scale than some other industries of the past.”

These businesses are able to grow very rapidly, yet retain some qualities – nimbleness and innovation, for instance – that stand successful small companies in such good stead. And digitisation itself means they can access a global customer base in a way companies could only dream of in previous decades.

Ray adds the consistent flows into index funds and exchange-traded funds (ETFs) is also making stock markets more concentrated, as the share prices of the largest companies are bid-up.

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He points out: “Add in the ever-growing importance of passive funds, which automatically reward the size of a company by investing more in it, creating a virtuous circle (although I’m not sure everyone thinks it’s virtuous!), and it’s not hard to see why some indices are dominated by a few large stocks.

However, Steven Smith, investment director at Capital Group, stresses the importance of distinguishing between long-term investment reality and short-term hype.

“While several semiconductor companies have successfully positioned themselves as pre-eminent AI computer platforms, arguably many other companies are benefiting from the hype, seeing potential but uncertain future AI value creation being called forward and reflected in their current share prices and valuations,” he warns.

Active managers’ dilemma

Active managers are paid to beat their benchmark index, and therefore need to differentiate their portfolios from it, so ideally they prefer not to hold large overweight positions in the index’s largest constituents.

But their success as managers - and by implication the security of their careers – is threatened when those dominant stocks outperform the wider index for any length of time, because that automatically puts managers with underweight positions at a disadvantage in performance terms.

“This was a clear feature in Europe for the first three or four months of 2024, where a handful of names had delivered a majority of the year-to-date benchmark returns,” comments O'Hara.

He adds that in such a situation, “it can be a challenge to outperform the benchmark in a differentiated way, meaning over time most funds get dragged into owning the same big performers.” That crowding in turn feeds back to leave markets more vulnerable to volatile rotations.

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So, what can managers do in the face of this kind of pressure?

It’s important that they assess each of these mega-stocks on its own merits as a long-term outperformer. Some may be more inherently attractive than others in terms of fundamentals, and therefore worth holding in line with the benchmark or even going overweight.

O’Hara explains that managers need to make use of certain stocks as “risk management tools” in this regard. “We have to be sensitive to what can hurt us in the benchmark. In this respect it’s fine to hold some of the big stocks at benchmark weight, although it can mean your active share [the extent to which the portfolio deviates from the benchmark] reduces, which may come under scrutiny from clients.”

But as a Europe fund manager, O’Hara has access to more diversity than some peers focused on other regions. Levels of concentration in Europe are markedly lower than in other regions, and the biggest names are also spread across a range of sectors, including pharma, luxury goods and food as well as technology.

“That variation at the top of the benchmark means there is also opportunity to generate alpha from avoiding big names that you think will underperform the market (i.e. their weighting will shrink),” he adds.

Looking for value outside the biggest stocks

Another option is simply to step back from the benchmark to some extent. Ray suggests managers could make clear to investors that they will not chase index returns and look instead for other stocks further down the market-cap spectrum that compete or do different things.

Smith takes a similar line. “It’s clear that there are plenty of attractive long-term investment opportunities outside the handful of mega-cap companies that have caused the recent spike in concentration,” he adds.

But that is likely to mean shorter-term underperformance of the benchmark. Fund managers, therefore, need to be able to take a long-term perspective that can give them the capacity “to invest in the next generation of the global economy and stock market winners rather than focusing solely on the leaders of today”.

Baker takes a similar “patience pays off” perspective. Unsurprisingly, given the multi-manager approach taken for the Alliance Witan portfolio, he favours selective diversity across geographies, sectors and investment styles.

However, many fund managers will be largely constrained by their mandates as to how widely they can cast their investment nets.

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For investors, assessing how best to mitigate the investment risks associated with concentration can be a tricky issue best left to active managers. On the one hand, the more dominant a stock, the more damage share price falls can do to a portfolio; but on the other, that company might nonetheless have an enduring capacity to dictate the pace and direction of change.

Ray provides a classic example: “No one got rich betting against Google [Alphabet Inc Class A (NASDAQ:GOOGL)] by selling it and buying Ask Jeeves 20-plus years ago, even though some would have said Google was overvalued at the time.”

But there are other avenues to explore. Multi-manager funds with a broad-based mandate can provide at least some exposure to key sectors of the index. As Baker observes: “We have exposure to many companies that dominate their markets but are also willing to not hold very large companies that have become richly valued.”

It’s also worth looking beyond the US to regions such as Europe, where leading global technology and healthcare companies are very much in evidence, but concentration is lower and there’s more diversity in the leading sectors.

Finally, Ray suggests that smaller company specialist funds in the UK and elsewhere can give investors exposure to much less well-known but impressive companies that haven’t yet experienced a weight of capital driving share prices higher. He picks out Rockwood Strategic Ord (LSE:RKW) for the UK and The European Smaller Companies Trust PLC (LSE:ESCT) as two examples.