In the past eight months since the invention of artificial intelligence, there has been a lot of talk about the growing concentration of stock indices. Many articles begin by noting that the trillion-dollar IT club now makes up a significant portion of the S&P 500 index, either due to the hype around AI or a rotation by investors following a sell-off of similar stocks a year ago. Most people agree that this high concentration is not ideal, but there is little consensus on the specific reasons why. However, Liberum strategists Joachim Klement and Susana Cruz offer an interesting suggestion: in a more concentrated index, it becomes harder for stock pickers to outperform the index because success is more reliant on timing the performance of the largest stocks rather than selecting the best-performing stocks.
For stock pickers, this poses a challenge. Fund managers often choose to allocate their positions in a way that balances benchmark performance and the generation of alpha. For example, an active manager might have bought Coinbase this year using the cash they obtained from selling Nvidia, following their convictions.
In general, the gains in the equity market come from a small number of winners. In the current scenario, where passive and lazy money is flowing into value-weighted indices that are already top-heavy, any fund manager with convictions would likely underperform. Liberum’s analysis shows that Nvidia alone contributed 4.9% of the total return of the S&P 500 in the past 12 months, and when combined with the next four contributors (Apple, Microsoft, Meta, and Broadcom), these stocks accounted for two-thirds of the index’s overall return. On the other hand, the remaining 495 stocks in the S&P 500 generated a return contribution of only 5.2%. A similar situation is observed in the FTSE 100, where HSBC alone accounted for 1.5% of the total return in the past year.
There are other arguments against stock-market concentration. One possibility is that an index lacking diversification may be more volatile or overly exposed to specific themes. However, there is little evidence to support this claim. Another argument is that a narrow rally, with a few superstar stocks and many laggards, may be a symptom of weak competition. Some research suggests that stock markets dominated by a small number of successful firms may experience less efficient capital allocation, slower innovation, and slower economic growth. However, other studies have found no evidence to support this idea. It’s a mixed bag.
The clustering effect also raises concerns about the overvaluation of the largest stocks. It’s easy to look back in hindsight and say that certain stocks shouldn’t have held the title of the largest in the index for so long. However, markets are generally considered efficient until proven otherwise, and many analysts argue that these stocks are still undervalued.
Additionally, a narrow rally could be inherently more fragile than a broad one. Herd behavior and short-term returns are often seen as negative, regardless of their breadth. However, the definition of what constitutes a narrow rally is open to interpretation. Currently, the UK and European markets are relatively concentrated compared to their historical levels, but they are not as extreme as the US market.
Another perspective on stock-market concentration comes from a recent paper by Lisa Goldberg, who argues that big stocks keep getting bigger simply because they are big. This follows the power-law distribution effects seen in other areas, such as wealth inequality and urban population growth. According to Goldberg, weighting imbalances in indices are not as extreme as some may think.
Rather than getting caught up in defining what is normal, it may be more useful to remember that value is just one way of viewing the world. Value-weighted indices work well for passive investments due to their low rebalancing costs. However, for active managers, it may make more sense to use an index that equally weights each member, as this better aligns with their stock-picking strategies.
While equal-weight benchmarks are not commonly used because they are highly efficient, they can serve as a benchmark for assessing alpha generation. However, momentum has become more important than value since the start of the pandemic, causing equal-weight indices to underperform. This has contributed to the concentration we see today. The fact that it is becoming increasingly difficult for investors to find assets that can beat their preferred benchmark is a concern in the market.
In conclusion, the rising concentration of stock indices, whether driven by AI hype or other factors, presents challenges for stock pickers and raises questions about market volatility, competition, overvaluation, and the fragility of narrow rallies. While there are different perspectives on the issue, it is clear that the current concentration poses difficulties for investors who strive to outperform their benchmarks.
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