While there are always risks in markets, from here, it seems like things are pretty good right now for global multi-asset investors.
Growth is generally at or above trend, inflation continues to moderate, households and corporates are in good shape and the rate-cutting cycle is either here (in the case of the European Central Bank) or likely coming soon (Federal Reserve and the Bank of England).
Many clients we speak with are taking advantage of this positive environment. With reasons to be bearish fading in the face of a resilient growth backdrop and falling inflation, investors are in large part overweight risk assets, such as equities and credit
While it is important for investors to recognise a constructive environment when it comes to pass, we must also grapple with the potential risks given how far markets have come in the last few quarters. A few are top of mind: resurgent inflation, the potential for slowing growth and the ever-present shadow of unpredictable and hard-to-measure geopolitical risk.
While all of these and more have the potential to derail the positive mood music in capital markets, one area of particular interest to many clients I speak with is concentration risk in equity markets. The potential for negative earnings surprises from the magnificent seven is a top risk to equity markets in the near term.
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For multi-asset investors, being this reliant on a handful of companies is an unfamiliar and uncomfortable place to be. The benefit of multi-asset investing lies in the diversification inherent in owning a balanced portfolio of underlying securities across different asset classes, ostensibly producing an overall risk/return profile that is greater than the sum of its parts and not overly exposed to one company, risk factor, or asset class.
The prevailing use of market-cap-weighted indices for portfolio benchmarks, coupled with the extreme dominance of a few large-cap technology stocks within these benchmarks, presents a significant challenge to this core tenet of diversification in a multi-asset portfolio.
The concentration conundrum
Whether or not market concentration in and of itself is negative for markets is hotly debated. For the purposes of this article, however, we’ll focus on one thing that is abundantly clear: market concentration, by definition, makes equity market indices less diversified.
With just seven stocks accounting for around 30% of the S&P 500, investors are faced with a choice: 1) own a highly concentrated equity portfolio where the fate of a number of stocks dictates total returns or 2) underweight these stocks to deliver a more balanced risk footprint, and in doing so risk significant performance dispersion from the market benchmark.
In the recent past, the concentrated portfolio has been the right choice. The Magnificent Seven have delivered significant outperformance both in terms of price appreciation and earnings growth.
While the promise of AI has yet to be fully realised, labelling this period of concentrated performance a “bubble” or “euphoria” misses one crucial point: the fundamentals back the performance. These companies are delivering tangible earnings growth in line with performance. Being underweight in the name of portfolio diversification would have led to significant underperformance.
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However, mega-cap tech stocks are not immune to volatility and significant drawdowns, as we witnessed in 2022, and drawdowns among the Magnificent Seven stocks have ranged from 30% to 75% over the last 10 years. Given the weight of these stocks in many multi-asset portfolios, a repeat of these drawdowns could pose significant challenges for risk management and performance.
In discussions with clients about managing this balance between diversification, performance and risk, global small-cap equities have increasingly emerged as one potential avenue for reducing concentration risk within global equity portfolios. Using a barbell approach that pairs large-cap equity exposure with global small-cap investments can provide a more balanced equity allocation.
Why small caps now?
In our view, small caps offer a more diversified sector footprint and the prospect of attractive total returns. Despite lagging large-cap stocks in the past decade, small caps have outperformed over longer time horizons. Recent underperformance of small-cap stocks has reached extremes and created a wide valuation gap that is near a 30-year peak.
We believe this gap is likely to narrow or close in the next decade, as small-cap stocks may be less impacted relative to large cap from structural forces, such as deglobalisation, increased regulation, and more divergent economic cycles.
Investing in small caps carries its own risks and they tend to be more volatile than large-cap equities. However, small-cap stocks can offer attractive earnings growth despite having a higher share of unprofitable companies than large-cap stocks.
This is because the unprofitable companies are concentrated in a few sectors, such as biotech and software, while the profitable companies are growing their margins and cash flows across a diverse range of industries.
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In addition, the lower levels of research and coverage of small-cap stocks by analysts presents opportunities for active managers to identify undervalued “hidden gems” and potentially generate positive excess returns.
For a global multi-asset investor, small caps should also be viewed in the context of their marginally lower correlation relative to large caps with global equity indices and potential diversification benefits within a broader multi-asset portfolio.
Facing the equity market concentration challenge head-on
In summary, equity market concentration presents a risk-management challenge, demanding that investors across the spectrum make difficult portfolio management decisions.
A barbell approach, using small caps alongside large-cap technology stocks, may offer multi-asset investors a means to navigate concentration risk and achieve a more balanced risk footprint, while also allowing for participation in any continued outperformance of the magnificent seven.
John Mullins is multi-asset investment director at Wellington Management
