Why today’s high market concentration in a few company stocks could spell danger for passive investing

Global share markets have become increasingly top-heavy. At the end of October, the ten biggest stocks in the index of the 500 largest US company shares (equities) made up a record 31 percent of the market (see chart 1). In other words, the US stock market has an unusually high concentration in the equities of these ten companies. The companies include well-known names such as Amazon, Apple and Microsoft.

Chart 1: How much of the index of the 500 largest US company stocks is comprised of its ten largest stocks

Source: LSEG Datastream, and SIM. Data 31 December 1981 to 31 October 2023. Constituent weights are available monthly since May 1996 and annually previously.

This poses a problem for investors trying to build diversified portfolios, as a significant proportion of their investments may be held in a relatively small number of shares. In the view of Schroders Personal Wealth (SPW), disproportionately large shareholdings in a few companies can reduce effective diversification and thereby lead to greater investment risk.

Schroder Investment Management (SIM) research shows that, historically, investors passively tracking the US stock market would have lost out on the higher returns that often follow periods of high concentration. By passively tracking the US stock market I here refer to holding company shares in the same weightings as the index of the 500 largest stocks. This is known as a ‘market-cap-weighted’ approach. So if the index has a 10 percent holding in a company stock, then a fund passively tracking the index would also hold 10 percent in that stock. In short, it would try to perfectly replicate the proportions and holdings of the index.

Passive investing is typically contrasted with active investing. By active I here mean an investment approach that attempts to beat the performance of the index through stock selection and stock weightings. Active investing, by definition, does not try to passively replicate the index. One of SPW’s key principles is to take an active approach to investment management.

What is known as ‘concentration risk’ is not just an issue for the US stock market. The US comprised 63 percent of the global market at the end of October, based on the constituents of the MSCI All Country World Index (ACWI). So globally diversified investors could end up with a lot in US equities and, consequently, large holdings in just ten company stocks. Staggeringly those ten stocks make up nearly 18 percent of the global market, the same as Japan, the UK, China, France and Canada combined (see chart 2).

Chart 2: The ten biggest US company stocks have the same value as the Japan, UK, China, Canada and France stock markets combined

Source: LSEG Datastream and SIM. Weight in MSCI AWCI index. Data to 31 October 2023.

So should investors worry about index concentration when it comes to future returns? One way to assess this is to compare the performance of a standard, passive, market-cap-weighted index and its equal-weighted cousin.

The equal-weighted version of the index of the 500 largest US company stocks would hold 0.2 percent (or one-five-hundredth) in every stock in the index. In other words, it would hold an equal weighting in each stock. Consequently, it would only have a 2 percent allocation to the ten largest US stocks, rather than the 31 percent allocation held in the passive, market-cap-weighted version. This means the equal-weighted version is more diversified than the passive version.

If the equal-weighted version of this US index performs more strongly than the passive, then the smaller companies are performing more strongly than the larger companies in the index. Under this circumstance, investors would be better off allocating money away from those large company stocks that passive investments could have the greatest exposure to.

Benefits of deviating from a passive approach

SIM found a notable historic trend in how the equal-weighted version performed relative to the passive when concentration is high in the index of the 500 largest US company stocks. This is shown in chart 3.

Chart 3 shows the difference in five-year returns between the equal-weighted and the passive versions. And it shows that, when the 10 largest company stocks comprise a large percentage of the index, then the equal-weighted version goes on to perform significantly more strongly than its passive cousin.

So deviating from the passive approach has historically been a winning strategy when concentration has been high. Moreover SIM found the relationship to be positive, although weaker, when assessed over shorter time periods than five years.

Chart 3: More diversified (equal-weighted) index funds go on to perform more strongly than their passive equivalents when the US stock market has high concentrations in a few company stocks

Source: LSEG Datastream and SIM. Data from 31 December 1989 to 31 October 2023.

Today’s 31 percent weighting for the ten largest stocks represents a historically high concentration. Chart 3 suggests that holding equal weights in the index of the 500 largest US company stocks could potentially lead to significantly higher returns than the passive approach, due to current high concentrations. In fact the chart suggests this could potentially be by more than 15 percent a year for the next five years.

Even so, forecasts of future performance are not a reliable indicator of actual results while past performance is not a reliable guide to future returns. But chart 3 provides a strong case that the passive, market-cap-weighted strategy favoured by many could struggle compared with others that have more freedom to avoid such high concentrations.

In conclusion, when the equity market has become very concentrated in a few company stocks, investors have done better by allocating away from those stocks. This could potentially favour an active investment approach.