The US stock market is now highly concentrated to the Magnificent Seven
The ASX also has concentration risks
What investors can do to manage this risk
Soaring tech share prices have driven the US stock market concentration to unprecedented levels and pushed valuations to a record premium relative to other markets.
Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla – dubbed collectively as the “Magnificent Seven” – have grabbed a much bigger share of the S&P500 Index thanks to their stellar performance.
Richard Saldanha and Joao Toniato at Aviva Investors believe this trend could persist, and investors need to be aware of the implications.
“If you’re a US passive investor, you may believe you’re getting broad market exposure, but the fact remains 30 per cent of your money is in just seven stocks,” said Saldanha.
“Even if you’re exposed to global equities, the dominance of the US market means the same seven stocks account for 18 per cent of your investment.”
Although it’s quite conceivable that this high degree of concentration will persist a while longer, history suggests current high levels will not persist indefinitely.
“While we may not know when some of these stock valuations normalise, they almost certainly will at some point. You don’t want to be stuck on the wrong side of that trade when they do,” Saldanha says.
Sell or keep?
Portfolio managers such as Saldanha are now facing a dilemma.
On one hand, shunning these seven stocks altogether could result in the portfolio underperforming the benchmark. On the other hand, keeping these richly valued stocks runs counter to the philosophy of seeking undervalued stocks.
Saldanha says he takes a pragmatic view of this problem.
“When it comes to the Magnificent Seven, ultimately the question one needs to ask is: is the price you’re paying justified? If it isn’t we simply don’t own them,” Saldanha says.
Joao Toniato meanwhile argues that while the level of concentration within the US stock market may look unsustainable, it would be a mistake to lump The Magnificent Seven into the same bucket.
“Their valuations are simply not comparable to each other,” said Toniato.
Tesla, for example, trades on a 12-month forward price/earnings ratio of around 60x (on March 4th). Amazon is trading at 39x, while Nvidia and Microsoft were trading at forward P/Es of around 30x.
“While that is not cheap relative to a market trading on a forward P/E of around 20x, both companies (Nvidia and Microsoft) are expected to be big beneficiaries of the growth in AI,” said Toniato.
Concentration risk on the ASX
The Australian stock market also has a concentration problem, although not as pronounced as the US market.
The benchmark index ASX 200, which contains the top 200 companies by size, accounts for over 80% of the total stock market.
The ASX has a total of 11 sectors, and as the pool of eligible ASX stocks is relatively small, some sector indices only contain a handful of companies.
Size of each ASX sector compared to the overall market cap:
Financials: Approximately 30% to 35%
Materials/Resources: 15% to 20%
Real Estate: 10% to 15%
Healthcare: 7% to 10%
Industrials: 5% to 10%
Consumer Discretionary: 5% to 10%
Information Technology: 5% to 10%
Energy: 5% to 10%
Utilities: 3% to 5%
Consumer Staples: 3% to 5%
Telecommunications: 2% to 4%
ASX COMPOSITION
Source: MarketIndex
The Aussie market is also too concentrated by securities, with the top 10 stocks representing around 40% of the S&P/ASX 200 index.
BHP alone makes up around 10% of the overall market, resulting in cyclicality (due to the cyclical nature of commodity prices) becoming more pronounced.
The top 10 ASX stocks by size are:
1. BHP Group (ASX: BHP)
2. Commonwealth Bank of Australia (ASX:CBA)
3. CSL (ASX:CSL)
4,5,6. National Australia Bank (ASX:NAB), Westpac (ASX:WBC) and ANZ Banking Group (ASX:ANZ)
7. Macquarie Group (ASX:MQG)
8. Woodside (ASX:WDS)
9. Fortescue Metals (ASX:FMG)
10. Wesfarmers (ASX:WES)
Regular rebalancing is the key
The concentration to bank stocks is intrinsically linked to housing and property market in Australia.
Many Aussies are worried about this concentrated exposure, however not many do anything about it.
One of the best ways to reduce your portfolio’s concentration risk is through regular monitoring and portfolio rebalancing.
Investors should regularly review their portfolios to make adjustments as needed. This may involve selling stocks in your portfolio that have become overweighted, and reinvesting the proceeds into underweighted stocks to maintain the desired asset allocation.
“Rebalancing is a crucial component of maintaining a healthy investment portfolio. It ensures that your asset allocation remains aligned with your investment goals and risk tolerance over time.” – said John Smith, chief investment officer at ABC Capital Management.
“While it may seem counterintuitive, rebalancing often involves selling winners and buying losers. This disciplined approach forces investors to sell high and buy low, which can enhance returns and reduce portfolio volatility,” said David Lee at DEF Investment Group.
“Investors should rebalance their portfolios at regular intervals, such as annually or semi-annually, to ensure that their asset allocation remains on target. However, it’s essential to avoid excessive trading and focus on long-term strategic goals,” said Emily Chen of GHI Financial Services.
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