By Andrzej Pioch, Lead Fund Manager, L&G Multi-Index Funds
A typical broad global equity benchmark has around two-thirds of its stocks domiciled in the US1. Perhaps unsurprisingly, global equity indices therefore share the majority of their top 10 constituents with US equity indices, and the typical overall portfolio overlap between the two is currently over 60%2.
Comparing the S&P 500 index’s top five holdings in 2009 versus today, they share only one name – Microsoft – and the concentration in top holdings has also increased from 10% to over 26% as at 25 January 2024. This has resulted in recent positive US equity index performance being driven by a relatively small number of stocks, namely the ‘Magnificent 7’ of Apple*, Amazon*, Alphabet*, Meta*, Microsoft*, Nvidia* and Tesla*. We believe this poses concentration risk not only for investors who hold US index exposure, but also for multi-asset strategies that hold global equity indices with common underlying exposure.
What can we do about it?
Some multi-asset strategies that align their equity exposure with global equity indices may increasingly look like a material bet on mega-cap tech companies becoming even larger. So, what can investors do to manage that risk?
They could always move back to active management for their equity exposure, where the manager might lower exposure to the ‘Magnificent 7’ and offer exposure to other themes that they believe could provide more attractive risk-adjusted return potential. However, this may introduce other types of stock-specific risk given the active nature of the approach and may potentially increase costs.
If they would like to preserve the simplicity and transparency of the index approach, they essentially have three options:
- Use regional equity indices to build a more geographically-balanced equity portfolio. This preserves the transparency of the market-cap weighted index approach within individual regions, but lowers reliance on US stocks and in particular US mega-cap tech within the overall portfolio.
- Complement their global market-cap exposure with a single- or multi-factor equity index exposure, which will tilt their exposure towards equity factors that have been shown to reward investors with long-term premia such as value, low volatility, quality, size or momentum.
- Complement their market-cap exposure with equal-weighted investments leveraging emerging areas shaping our future. When identified and designed carefully, thematic portfolios can potentially act as a diversifier, while providing access to important areas such as clean energy, access to clean water and cyber defence.
In our L&G Multi-Index range, we seek the cost-effectiveness, diversification and transparency an index approach can deliver to individual asset classes, and then we combine this with dynamic asset allocation.
With a wide range of L&G index funds at our fingertips, we don’t need to accept global benchmarks’ implicit biases or concentration risks. That’s why we seek to spread our equity risk across a number of regional equity indices and gain exposure to long-term thematics via well-diversified L&G ETFs.
For example, while we are positive on artificial intelligence (AI), we don’t believe the ‘magnificent seven’ are the only companies set to benefit from this theme. We have spread our allocation equally over approximately 60 companies with distinct portions of their businesses and revenues derived from AI, that have the potential to grow in this space.
While certain index benchmarks have become increasingly concentrated, when introducing new risks to index investors we need to be careful not to throw the index baby out with the bathwater.
We think the innovation and ingenuity we have seen in this space makes index investing an exciting area to explore, not just for growth investors but also those looking for potential higher income, or who want to go further when it comes to ESG investing. That’s why they are a core foundation of our entire Multi-Index fund range.
Sources:
1 The MSCI World, for instance, has a 69.7% allocation to US stocks. Source: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb
2 Nine of the top 10 portfolio holdings are the same in the S&P 500 and the MSCI World, and the overall portfolio overlap is around 66%. Source: Bloomberg data using ETFs as a proxy of index compositions, as of 02 October 2023
Key risk warnings
The value of investments and the income from them can go down as well as up and you may not get back the amount invested.
Past performance is not a guide to future performance. *The details contained here are for information purposes only and do not constitute investment advice or a recommendation or offer to buy or sell any security. The information above is provided on a general basis and does not take into account any individual investor’s circumstances. Any views expressed are those of LGIM as at the date of publication. Not for distribution to any person resident in any jurisdiction where such distribution would be contrary to local law or regulation. Please refer to the fund offering documents which can be found at https://fundcentres.lgim.com/
This financial promotion is issued by Legal & General Investment Management Ltd. Registered in England and Wales No. 02091894. Registered office: One Coleman Street, London EC2R 5AA. Authorised and regulated by the Financial Conduct Authority. Legal & General (Unit Trust Managers) Limited. Registered in England and Wales No. 01009418. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119273
