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Concentration risk is more than just a US issue

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2 days ago

September 18, 2024

Concentration risk is more than just a US issue

Concentration risk has been a hot topic this year, with the continued rise of the Magnificent 7 US tech giants carrying markets higher.

However, the narrowness of the rally has been a cause for some concern.

Enthusiasm for artificial intelligence (AI) has widened a bit to include other semiconductor stocks but gains from most other sectors in the US have been modest in comparison.

The size of the gains from some of these stocks (Nvidia is up 560% over the last two years, compared to 33% for the Large Cap S&P 500 index) also raises questions about how sustainable they are.

It is not just the US that is experiencing the effect of concentration risk. In Europe, the top 10 stocks in the Euro Stoxx 600 index account for more than 20% of its value, and gains from pharmaceutical giant Novo Nordisk and semiconductor ASML have significantly affected the performance of the broader market.

Perhaps surprisingly, the UK market also features a fair amount of concentration risk. The largest 10 companies in the FTSE 100 account for around 50% of its value, and the top 20 firms make up around 65% of the index by market capitalisation.

This raises a number of issues for investors. The obvious ones are that holding too small an allocation or not investing in these stocks is a guaranteed route to underperformance in rising markets. The reverse of this, of course, is that investing heavily in these stocks during a period of weakness can often also lead to significant underperformance compared to the broad market.

For active managers, periods of very strong performance from a small number of large stocks presents specific problems. The 5/10/40 rule for the construction of Ucits funds means funds are unable to invest more than 10% of their assets in the shares of a single company and that the total value of all holdings greater than 5% of a portfolio does not add up to more than 40% of its total value.

Looking at the UK as an example, at the end of June, the top 10 holdings of the L&G 100 Index Trust accounted for 48% of the portfolio.

AstraZeneca and Shell made up 9.1% and 8.9% of the portfolio, respectively. HSBC and Unilever were the other two stocks with an allocation of greater than 5% of the portfolio at this date and, together, these four stocks made up 29% of the portfolio.

An active manager looking to increase the weighting to these stocks has limited room before they start to bump up against the concentration rules.

A further issue for UK investors is the importance of overseas earnings for large-cap stocks. This makes currency exchange rates, particularly the dollar, a significant factor in the index’s performance.

Some of these factors explain the difficulty many actively managed UK equity funds have experienced trying to keep pace with or outperform the wider index in the last few years.

Although active managers can struggle in rising markets driven by a small number of stocks, well-managed funds offer the potential for significant outperformance during periods of weakness, as being able to steer clear of the biggest casualties during falling markets can have a big positive effect on long-term returns.

The other positive feature of UK equities is that they have been less volatile than US or European equities and have fallen less than these regions during recent selloffs.

The UK’s large-cap index has lagged behind the US significantly in recent years, but this year, it is doing a much better job of keeping pace.

With the outlook for UK economic growth improving and with UK retail sales relatively positive, the UK continues to offer an alternative to the tech-driven large-cap rally in the US.

Charles Younes is deputy chief investment officer at FE Investments

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