Index concentration: A problem or not?

Investors especially have a massive outperformance by the Magnificent Seven to thank for the rewarding year on the equity market in 2023. On the back of a years-long rally, the weight of the biggest US technology companies in the major stock indices has swelled to a possibly record-breaking high level. In the following article, we address the question of to what extent and for whom the top-heavy index concentration poses a problem, whether it’s a manifestation of a bubble, and how investors should deal with it.

 

Extreme in the short run…

The fact that the big (US) technology stocks have an ever heavier, direction-determining weight in the major equity indices is no longer headline-worthy in itself. Acronyms describing this trend have been around since the mid-2010s. FANG (Facebook (today Meta), Amazon, Netflix, Google) evolved into FAANG (with Apple) and then FAAMG (with Microsoft replacing Netflix). In light of the immense popularity of those technology stocks, the finance industry didn’t let the chance slip to launch a specific FANG+ index and associated derivative products later on. Last year, however, betting on the biggest technology stocks experienced a further remarkable escalation. Seven large-cap stocks – the FAAMG quintet plus Tesla and Nvidia – downright dominated the action on the US equity market. Instead of reaching for another acronym, the media invented a formal name for this group of stocks: the Magnificent Seven (Mag 7), because their performance in 2023 was indeed truly magnificent. The value of the Mag 7 rocketed by 76% while the value of the rest of the stocks in the USA’s blue-chip S&P 500 index (hereinafter to be called the S&P 493) increased by only 14%. The seven high flyers together accounted for more than 60% of the S&P 500 index’s performance for the year. The Mag 7 started out 2024 as well with a continued outperformance as some of its members hit new all-time highs. This raised the weight of the Mag 7 in the S&P 500 to a new high of more than 29%. Many investors are thus rightly asking themselves whether this top-heavy concentration could become a problem at some point.

 

Strong (out)performance | But also more volatility

Comparison of performance of “Mag 7 vs. the rest”, indexed as of January 1, 2023

Sources: Bloomberg, Kaiser Partner Privatbank

 

Corpulent | Is Ozempic needed?

Weight of the Mag 7 in the S&P 500 index

Sources: Bloomberg, Kaiser Partner Privatbank

 

…but nothing out of the ordinary in the long run

When it comes to answering the question of how extreme the current situation is, it helps – as it so often does – to take a comparative look at the past. Compared to the situation shortly before the bursting of the technology bubble around the time of the turn of the millennium, the S&P 500 index is more concentrated today. The weight of the top 10 stocks, at a good 33%, is higher than it was in the year 2000 (when it was almost 27%). However, the weight of the top 10 was actually even much higher for a while in the 1960s, when there was likewise a group of dominating stocks on the US market called the Nifty 50 (which included names like IBM, Coca-Cola, Procter & Gamble, McDonald’s, and Disney). And a handful of companies had an overproportionate weight in the overall market also in the decades prior between 1930 and 1960. Similar to today with the internet, e-commerce, and the recent rise of the artificial intelligence theme, back then telecommunication, electrification, and automobile manufacturing were the megatrends that sent certain industries and companies soaring. At that time, names like AT&T, General Motors, and General Electric, which are still known today (and still in existence), consistently ranked among the top 5 in the USA for decades. So, from a purely temporal perspective, the half-life of the Mag 7 looks far from over. The majority of the Mag 7 companies have been in the top 10 only since 2020, and Tesla and Nvidia in particular are veritable newcomers, historically speaking. Only Microsoft has managed to stay at the top of the heap of heavyweights for more than two decades already.

 

Change… | …is the only constant

Largest US stocks by market capitalization, 1930–2023

Sources: Dimensional Fund Advisors, Kaiser Partner Privatbank

 

Momentum begets momentum

Is the top-heavy index concentration a problem now? It is indeed, at least for many active fund managers. That’s because in order to achieve an outperformance of the benchmark (which is usually the S&P 500), they frequently underinvest in index heavyweights that supposedly are already richly valued. And even those managers who would like to place bets on index heavyweights often encounter regulatory obstacles because US investment funds that are registered with the Securities and Exchange Commission as “diversified” are not allowed to put more than 25% of their assets into single holdings that exceed 5% of the fund’s net asset value at the time of investment. Both phenomena are part of the reason why a record number of active fund managers lagged the benchmark last year. This creates a vicious cycle. The poor performance by active managers causes more money to constantly flow into the alternative: passive ETFs. In turn, by design, most of the money in passive ETFs automatically flows into shares of the largest companies, which tends to further drive up their prices. Price momentum fosters momentum in capital flows, and vice versa.

Aside from that problem, which possibly has further intensified the momentum of the Mag 7 trade in recent months, the heavy weight of a few stocks tends not to be problematic, according to the current state of financial theory studies. For example, studies from 2008 (FTSE 100) and 2022 (USA and BRICS) found no evidence that highly concentrated stock indices exhibit greater volatility than others do. Working papers have also negated the supposition that an index composed of a few superstars is tantamount to weak market competition. Meanwhile, the rather technical question of to what extent a rally driven by only a few stocks is a sign of an imminent price correction generally tends to get examined in technical analysis studies mostly in reference to short time frames. But here, too, the conclusion most times is that a narrow market – counterintuitively – is not problematic.

 

Shifted market forces | Passively managed assets are in the ascendancy now

Share of passively managed assets in the overall market

Sources: EPFR, Kaiser Partner Privatbank

 

The Mag 7 in the SWOT crosshairs

However, one problem could exist theoretically: if all of the top stocks were to have unrealistically lofty valuations, a bubble could burst, similar to what happened in the year 2000. That would lastingly depress the broad market. The SWOT analysis below answers the question of to what extent concerns of that kind are appropriate.

Strengths:

  • Arguably the greatest strength of the Mag 7 is a fundamental one. Their stellar performance over the last four years was almost exclusively attributable to revenue growth and profit margin expansion. Their slightly increased valuation, on the other hand, explains only a small part of their stock performance. At a forward price-to-earnings multiple of around 30x, the seven technology titans admittedly are far more expensive than the S&P 493 with their aggregate forward P/E of 18x. However, the Mag 7 in turn are growing at a much faster rate. The analyst community’s consensus estimate projects that the Mag 7 will boost their revenue by an average of 12% per annum through end-2026, outpacing the rest of the market’s revenue growth by a factor of 4x, and doing that at a profit margin that is twice as high and continues to climb (net profit margin 2023-26e: 21.8% vs. 10.2%). Adjusting for the robust growth, rich cash flows, and earnings quality puts the valuation of the Mag 7 much more into perspective and makes it characterizable as “fair”, which is a crucial difference compared to the technology bubble at the turn of the millennium. At that time, the valuations of the largest tech stocks were around twice as high as today, and instead of being profit-making machines like they are now, most of the tech companies back then actually burned cash.
  • Most of the top 10 companies of the past, which operate in the “physical world” of automobile production (General Motors), supermarkets (Walmart), or staple consumer goods (Procter & Gamble), eventually reached certain limits to their growth due to geographic or resource-related factors. The Mag 7, in contrast, operate for the most part in a virtual world of zeros and ones – the physical limitations to their expansion might be farther away than in previous cycles.
  • Although the members of the Mag 7 rank among the world’s largest companies, their respective free floats (the proportion of shares available to the public for trading in the open market) are relatively constrained, a fact that has been further worsened in some cases by regularly recurring stock buybacks (like at Microsoft for two decades now). This exerts a constant upward pull on the prices of the largest technology stocks in today’s investment world dominated by ETFs and index funds.

 

The Mag 7 are growing faster… | …and more profitably

Consensus estimates for revenue growth and net profit margins for 2023–2026 period

Sources: Goldman Sachs, Kaiser Partner Privatbank

 

Weaknesses:

  • The Mag 7 have outperformed the MSCI World index in nine of the last ten years, with the exception of 2022. The fact that this popular coterie of stocks is beloved by many investor groups such as retail investors and hedge funds (though not by actively managed investment funds, as explained above) and accordingly is disproportionately overrepresented in portfolios is arguably the greatest weakness of the Mag 7.
  • Many of those investors believe that the Mag 7 are made of Teflon. They want to be invested in them if the US economy slips into a recession because their (mostly) less cyclical business models give them defensive qualities. And they want to be invested in them if economic activity continues to hum because the Mag 7 benefit more than average from economic expansion. The problem, though, is that the past has shown that there are seldom any investments on financial markets that win on both heads and tails of a coin toss. And if they do exist, they’re not investments that almost everyone already has in his or her portfolio.

Opportunities:

  • The firing of the starting gun for the rally of the technology sector in general and the Mag 7 in particular coincided exactly with the launch of ChatGPT. Proof that this was not first and foremost a coincidental correlation but instead owed at least in large part to causation was delivered at the latest by the financial figures and guidance disclosed by the technology companies in their most recent reporting for the fourth quarter of 2023. The quintessence was that the world of artificial intelligence presents enormous growth opportunities that will be realized shortly. The leading US companies are once again in the pole position here, in large part because policymakers have already put legal obstacles in the way of European companies.

Threats:

  • Investors undoubtedly are pinning high expectations on an AI revolution. If the growth that they’re hoping for doesn’t materialize, one can expect to see those stocks affected suffer at least a short-term price setback. The performance of Tesla’s stock in recent months provides a visual aid for picturing such a scenario.
  • Big, bigger, too big? Many a US technology giant has grown so big in the meantime that questions about monopolistic dominance and inadequate competition are getting louder and louder. The Biden administration has since started to scrutinize the conduct of the technology giants more critically, which has been reflected not least by a string of antitrust lawsuits. No landmark rulings have been handed down in them to date, but the headwind for Big Tech looks set to tend to gain further intensity. A breakup of at least one of the Mag 7 companies in the next five to ten years is definitely a plausible scenario.
  • A change of leadership in the White House – read: Trump 2.0 – would likewise be no reason for the big technology companies and their shares to breathe a sigh of relief. Quite the contrary, in fact, Donald Trump could be plotting revenge and might turn up regulatory pressure on those companies that actively or passively put obstacles in his way after the storming of the Capitol. A newly reelected President Trump would at least ask why, after January 6, 2021, he was banned from Facebook, Instagram, and YouTube, why the Parler app was removed from the Apple and Android app stores, and why Amazon denied Parler access to its cloud storage service.
  • The strong performance by the Mag 7 ultimately also could become an impediment – a hindrance at least to their continued outperformance. Stocks, by nature, post huge excess returns versus the benchmark in the years before ascending to the top-10 summit. But once they have climbed that high in the market capitalization rankings, the excess return shrinks considerably and even turns negative from year five onward after having reached the top.

 

Big is beautiful? | It becomes harder for the really big stocks to outperform

Average annual outperformance of US stocks before/after belonging to the top 10

Sources: Dimensional Fund Advisors, Kaiser Partner Privatbank

 

Less synchronous in the near future

The Mag 7 all had a strong stock performance in common in recent years, but whether they all permanently belong in the same pot remains to be seen and is highly doubtful. In any case, the price drivers and risks are not the same for all of them. Nvidia and Tesla, for example, are increasingly dependent on relations between the USA and China not deteriorating further. There are also wide valuation and growth differences between the members of the Mag 7. Companies that are unable to undergird AI hopes fast enough with corresponding good revenue and profit figures risk decoupling from the rest of the group – downward with regard to their share prices. This process may have already begun because since the start of this year, if not before, the price trajectories of the seven stocks have increasingly been diverging. While Apple’s share price is stagnating, a weak outlook threatens to knock Tesla out of the US top 10 altogether. The Magnificent Seven in their current configuration may have already seen their best days. But everyone knows that the media never run out of new names for the future group of frontrunners, and if in doubt, they can turn to ChatGPT for help these days.

 

And then there were just five | New acronym sought

Performance of the Mag 7, indexed

Sources: Bloomberg, Kaiser Partner Privatbank

 

What now?

The SWOT analysis paints a neutral picture for the Mag 7 on balance. Investors do not urgently need to buy this group of stocks right this minute at peak prices out of fear of missing out on the artificial intelligence trend, but nor are these stocks so outrageously richly valued on aggregate that investors should categorically shun them. The top-heavy concentration in the major equity benchmarks likewise is not a real problem in this sense. However, investors should at least be aware that their exposure to a narrow set of stocks is greater than they perhaps suppose. The Mag 7 by now already make up a good 19% of even the globally diversified MSCI World index. Whoever exclusively invests passively in the well-known blue-chip indices implicitly holds a certain clump of Big Tech in his or her portfolio. This concentrated risk can be diluted by blending in equal-weighted index ETFs, small caps, or actively managed funds (on the condition of good stock selection). A strategy of that kind is likely to pay off over the longer term because one thing is still as true as ever on financial markets: sooner or later the law of reversion to the mean kicks in. When it does, the Mag 7, or possibly some new acronym, will underperform.

 

Time for a reversion to the mean? | This “law of nature” is bound to kick in eventually

S&P 500 index: capitalization-weighted vs. equal-weighted (rolling 12-month return)

Sources: Bloomberg, Kaiser Partner Privatbank

 

Oliver Hackel, CFA Senior Investment Strategist

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