Heavy stock concentration poses indexing problems
The relentless secular bull market in tech stocks has led to structurally high index concentration. While this is an age-old market phenomenon, it still poses a challenge for fund managers and index designers, particularly with passive investing having added fuel to the debate around index concentration.
There can be little doubt that index concentration in the US stock market is high. In 2024, the five largest tech giants – Apple, Alphabet, Microsoft, NVIDIA, and Meta – make up over 30% of the Nasdaq 100, while the top ten constituents of the Russell 1000, consisting mainly of tech stocks, account for over 30% of that index, the highest concentration level in its 45-year history. The US technology industry’s weight in the Russell 1000 hit an all-time high in July over three times the aggregate weight of the basic materials, consumer staples, energy, and utilities industries (the exact opposite of the situation in 2007/08).
At the same time, this is nothing new. FTSE Russell Insights (affiliated with FTSE Russell Indexes) has identified some striking examples of extreme concentration. For example, Nokia accounted for 70% of Finland’s stock market index in 2000, while Volkswagen had a 27% weight in Germany’s DAX30 in 2008, albeit on the back of an unprecedented short squeeze triggered by Porsche acquiring a stake in the company.
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Diversification/correlation
The problems with excess index concentration are well-known. To start with, it diminishes diversification, which is one of the main reasons to invest in an index in the first place. Diversification is a founding principle of modern portfolio theory and underpins asset allocation and portfolio construction. A key benefit is that it reduces “unsystematic risk,” which describes the risks unique to a single stock or sector – as opposed to systemic (or overall market) risk – by combining them with other assets that, optimally, have weak or even negative correlations. This then reduces portfolio volatility, as sharp declines in one asset or sector should theoretically be shielded or offset elsewhere.
By the same token, excessive concentration makes an index disproportionately vulnerable to moves in the relevant sector, and this increases volatility. High concentration can also give rise to other distortions, such as an index being an inaccurate barometer of the underlying economy.
Passive investing’s amplification effect
While index concentration itself may be nothing new, there’s a reason why it continues to be hotly discussed – the rise of passive investing and its growing dominance of market flows through index trackers and passive ETFs over the years. In crude terms, the problem many fund managers and analysts see is that this ongoing wave of “dumb” – or valuation-insensitive – flows into equity markets causes the stock market to move increasingly in lockstep. In other words, it amplifies the above mentioned problem of suboptimal diversification/excessive correlation. A virtuous cycle takes shape, where money naturally flows to the same outperforming stocks (as passive strategies use capitalization-weighted indices like the S&P 500) and those stocks go even higher, causing yet more flows into those stocks. The ultimate concern for market participants is that this eventually ends in a proper bear market, inflicting unrecoverable losses on investors, with spillover into other markets and the real economy.
Some analysts have identified other issues with passive investing, such as its impact on market structure. For example, with an ever-larger portion of stock held by passive funds, the free floats of stocks may be lower than the official numbers suggest. A fund manager who wishes to buy stock on the market can only really buy from other active investors. This may help to explain some of the outsized daily moves seen in mega-cap stocks that used to be rare but are common today, particularly during earnings season.
Other analysts have weighed in on the other side of the argument. A recent article in the FT called “Slaying some of the biggest passive investing bogeymen” references research by Goldman Sachs analysts that dismisses many of these claims. For example, their research suggests that passive investing has had a limited impact on correlations and valuations.
Regulators alert to risks
Whether the risks are overblown or not, they are not lost on regulators who look to protect investors – in particular retail investors.
In the US, investment companies such as mutual funds that market themselves as “diversified” must follow what is known as the “75-5-10” rule, requiring that the fund:
- Must have at least 75% of the fund’s assets invested in the securities of other issuers
- Cannot invest more than 5% of its assets in any one company
- Cannot own more than 10% of a single company’s outstanding stock
The EU has a roughly equivalent measure called the “5/10/40” rule, which means that funds can only invest up to 10% of assets in a single issuer, and any positions worth 5% or more of the fund must not exceed 40% on aggregate.
Index designers look to limit concentration risk
Many mutual funds track indices, and it might be thought that index designers would have to reflect the fund diversification rules in their design. In fact, because regulators recognize that index trackers are less likely to incur stock-specific risk, they have granted index tracker fund providers a degree of flexibility.
Index providers such as FTSE Russell design indices to tackle concentration risk. One such method is capped indices where individual index constituents are capped on a quarterly basis – a variant on the standard market-cap weighted index.
While overconcentration typically unwinds eventually (no bull market lasts forever), as long as the current “winner takes all” age of mega-cap domination persists, concentration risk promises to remain topical. Taken in tandem with fund concentration regulations, index providers hope to ensure that their modified index offerings can adequately limit concentration risk while protecting fund investors.
Intuition Know-How has a number of tutorials relevant to the content of this article:
-
Equity Markets – An Introduction
- Equity Indices
- Asset Allocation – An Introduction
- Risk & Return – Efficient & Optimal Portfolios
- Portfolio Management – Passive vs. Active Approaches
- Mutual Funds (US) – An Introduction
- Mutual Funds (US) – Investing
- Mutual Funds (US) – Types
- ETFs – An Introduction
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