Amid market concentration, is it time for an active approach?

Published in The Sunday Times on June 23rd 2024.

A few years ago, many people had never even heard of Nvidia. Yet last week it overtook Microsoft to become the largest company in the world with a market capitalisation in excess of $3.3 trillion (before falling back later in the week).

The US stock market is abnormally concentrated. You’ll have read plenty about it here and in many other publications, as the S&P 500 grows more top-heavy, thanks largely to the dominance of an increasingly narrow set of technology companies. 

The big three, Nvidia, Microsoft and Apple, now boast over $8 trillion in market cap, which is 15% of the U.S. stock market - a level of concentration we haven’t seen since the 1960’s. 
History tells us that owning the largest stock can ultimately be a bad investment. So is it time to sell Nvidia? Is market concentration that unusual? Can it be justified? And does it even matter? 
In a new paper on market concentration, Michael Mauboussin of Counterpoint Global provides some answers to these important questions. 

On the point of the perils of owning the top stock, it seems that there is a limit to size and growth - trees don’t grow to the sky after all. Mauboussin shows that from 1950 to 2023 the average annual return of the top stock relative to the S&P 500 was negative 1.9%. However, the second and third-largest stocks fared considerably better. The second largest stock had an average annualised return of +2.6% over the index return, with the third largest returning +1.6 percentage points more than the index. 

By any measure, market concentration is high by historical standards and the rate of increase over the past decade is the steepest in history. At the end of 2023, the S&P’s ten largest companies accounted for more than 27% of the index (and this week it reached 35%). The lowest concentration of the top-ten since 1950 was 12% in 1993, and the level was 14% as recently as 2014. 

But it turns out that the US market is not that concentrated by global standards. In fact, it’s unusually diverse. Of the twelve major markets included in the UBS Global Investment Returns Yearbook, only Japan has less concentration in its biggest companies. 

However, it’s important to note that the U.S. was approximately 60% of global equity market capitalisation in 2023, so changes in the composition of the U.S. have an outsized impact on the aggregate totals for global indices. So, it’s one thing to say the US is more diverse than the French stock market. But the US matters much more to every global asset allocator.

Does it really matter? It depends on who you are. For a portfolio manager concentrated benchmarks are awful because they’re that much harder to beat. Active managers have a natural propensity to underweight the biggest stocks. It is hard to produce excess returns relative to an index that has a small number of stocks making an outsized difference in the overall results. 

What’s very clear from the analysis is how particularly difficult the last ten years have been for active managers. The decade 2014-2023 was a remarkable outlier in terms of the concentration of returns across the top-three stocks. In the last decade, the average annual excess returns of the top-three stocks were 15.9%, 9.8% and 8.4% respectively. Active managers have never had it so bad. 

If you’re not running a portfolio, you’re more likely to be interested in what concentration means for the market. And it turns out that the stock market does better during periods of rising concentration. The results were pronounced for the concentration changes associated with the inflating and deflating of the dot-com bubble, with compound annual returns of 23.5% from 1994 through 1999 and just 3.6% from 2000 to 2013.

Stock prices tend to reflect expectations about future value creation. Stock market concentration may be justified if the market capitalisations mirror the value creation prospects of those companies. 

The top-ten stocks at the end of 2023 were 27% of the market capitalisation and the companies earned 69% of the economic profit. From 1990 to 2023, the top-ten averaged 17% of the market capitalisation and 46% of the economic profit. As Mauboussin argues, “The expectations priced into the market may be wrong, but it would be hard to argue that the market capitalisations of the largest companies are without some fundamental support.”

There are many legitimate concerns for investors to have about a market that’s as concentrated as the one we have today. But my biggest takeaway is in relation to active managers. The arguments against active management are exceptionally easy to make. It has faced not just a headwind, but a hurricane in the last decade. Maybe its time is nigh, so I’m willing to overlook many of the counterarguments and lean against the current trend towards passive.   
 

Source: Data is sourced from Bloomberg as at market close 29th December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.