Concentration Risk

The world is becoming a riskier place—and not just at the obvious level of wars and climate change. Equity markets are becoming intrinsically riskier because they are becoming more concentrated.

Taking the iShares MSCI ACWI ETF as a proxy for global equity weightings by country, the US was 61.92% of the fund in September. Apple is the largest stock in the ETF (and, of course, the index), weighing in at 4.33% of the portfolio. That doesn’t seem too hefty, but that’s more than any country weight, other than (obviously) the US, and then Japan at 5.05%. The UK comes third, at 3.61%. By way of comparison, China—the world’s second-largest economy, and largest on a purchasing power parity (PPP) basis—has a 2.62% weight, or roughly the same weight as Amazon.

In March 2009, just as markets rebounded from the nadir of the global financial crisis, the US weight was 43.16%. The US equity market’s share of the whole has therefore increased by almost 20 percentage points in a decade and a half.

The US’ share of global GDP in 2023 was 26% in nominal terms, or 15.5% on a PPP basis. China’s was 18.4% in nominal terms, though much of this is uninventable. You may feel as happy about Chinese exposure as an ice bath now, but the contrasty is startling.

Not only have we seen a skewing of the global equity market to its largest member since the GFC, there has been a significant concentration within that market itself. The six largest stocks in the S&P 500—Apple, Microsoft, Nvidia, Amazon, Meta, and Alphabet—make up just under 30% of the index. In March 2009, the top six stocks were about 15% of it.

Free lunch

Diversification is the nearest thing to a free lunch in investment, a vital way of mitigating risk. The most fundamental way this operates is at the level of asset classes. Some go up, others languish in the doldrums, and yet others fall off a cliff. However, those same laggards can act as a portfolio buffer when the frontrunners’ fortunes change, dampening volatility.

The same is true within asset classes. Different companies behave differently at various times across the economic cycle. Banks perform well early in the economic cycle, as optimism increases and companies and individuals want more access to capital; utilities, on the other hand, are the tortoise of investment sectors, with steady income and bond-like characteristics. The factors that drive each sector have very little in common, and this is reflected in their return characteristics. You want a mix. An unanticipated external shock may send a sector to hell in a handcart.

Investing by numbers

It’s a numbers game: the more the merrier—to a point. If you increase the number of securities in your portfolio, the risk posed by an individual security—known as its idiosyncratic risk—diminishes. But it doesn’t diminish in a linear fashion: a portfolio of 40 shares isn’t half as risky as one of 20. Assuming an equal correlation between shares, adding a single one to a portfolio of a handful of securities will lower the risk more dramatically than to a larger portfolio.

This is the cornerstone of Modern Portfolio Theory, pioneered by Harry Markowitz in the 1950s. It postulates that the relationship between risk and return is not linear: a combination of dissimilar assets will tend to have a better risk-return profile than any individual asset alone. Adding just a small amount of a less-correlated asset to a portfolio leads to better returns with lower volatility over time.

I previously looked at the trend towards passive investing. It has many advantages—not least, cost. However, it can come with the concentration risk explained above. One way to counter this is, of course, to go active. Not all active funds, however, are created equal (that is, after all, the point of active management). But they can increase or decrease these concentration risks.

For example, the five largest Equity Global funds in the UK market have an average US exposure of 68.2%—considerably higher than a passive global exposure. That’s not to imply these are bad funds—that higher exposure will likely have served them well—but investors need to be aware of this risk. Likewise, the largest Equity US funds will tend to have exposures to the S&P broadly aligned to their passive weightings. Again, these will be bets that have paid off so far.

One can beat the market by being genuinely contrarian, however. Lipper analysis shows that the third-highest returning Equity Global fund over three years has a less than 20% exposure to the US. But, to be fair, it’s a rarity.

Spread your bets

Another—passive, and therefore cheaper—way to dodge the concentration bullet, especially in the US market, is to favour funds that track equal-weighted indices rather than market cap-weighted ones. This means that each company within an index carries the same weight. In an equally weighted S&P 500 tracker, assuming full index replication and a literal equal weighting, Apple will have a weight of one-fifth of a percent instead of more than 7%. Conversely, companies at the lower end of the index may have about 20-times their active weight.

What stands out from the chart below is the spike in interest in Equal Weight ETFs in September. Indeed, over the month, £2.52bn of £5bn (50.4%) invested in Equity US on the LSE has gone to equal weighted ETFs, while YTD that has only been £4.47bn (13.7%). However, that seems to have been a blip rather than a trend (so far), as cap-weighted flows came roaring back in October and November, with the latter seeing the highest flows to Equity US on record .

Equity US Cap- v Equal Weighted LSE-listed monthly flows (£bn)

Source: LSEG Lipper

The point being made isn’t that concentration risk is bad: it has increased because certain stocks have grown massively since the GFC. Those who have been along for the ride have been rewarded. The stocks that have driven this—Apple, Amazon, etc—are strong businesses with robust earnings. So far. But those enjoying the rewards need to be aware of the attendant risks.

This article first appeared in Personal Finance Professional.