The balance between Concentration and Diversification

Spotlight: Concentration vs Diversification

Imagine investing £100 in a fund that tracks the global equity index (e.g. MSCI ACWI index), which includes over 2,750 large and mid-sized companies from both developed and emerging markets. You might expect to be invested in a good mix of global companies, but did you know that nearly £20 of your investment would be in six technology (tech) giants (Apple, NVIDIA, Microsoft, Amazon, Meta and Alphabet) (source MSCI as at 30 August 2024), making it less diversified than you may have thought and putting a lot of reliance into one sector of the global equity market. This £20 compares to 22p for the top 6 companies if you held an equal weighting across all 2,750 stocks in the index instead. If we look in terms of country exposure, about £64 would be in the US, with smaller amounts spread across Japan, UK, Canada, France and other countries, (source MSCI as at 30 August 2024).

When building portfolios there is a delicate balance to tread between concentrating your money into your highest conviction ideas and limiting the negative impact on your portfolio if things do not go your way. While allocating too much money to one company or sector can increase risk, investing across too many companies can reduce returns. We are always looking for that “goldilocks” just-right balance. In August this year, equity markets were spooked and fell, highlighting the significant concentration within indices. Tech and artificial intelligence (AI) related stocks like Nvidia, which had previously boosted index returns, are now causing concern among investors. This tech boom follows a recurring pattern where a certain market segment becomes highly popular, reach high valuations and leave investors with unintentional overexposure to a few top companies. For investors looking for wider market exposure, and hence investing in index or passive investments, transitioning from a market cap-weighted (where you hold a higher allocation to the bigger companies) to an equal-weighted (where you hold the same equal weighting to all companies) strategy can help mitigate concentration risks, though it might also reduce returns by increasing exposure to underperforming stocks.

Historical data shows that even the best-performing active managers (who aim to beat the market) don’t consistently outperform. A 20-year study by WTW (who are the investment engine behind our portfolios), starting in 2003, revealed that two-thirds of the top 25% of active managers typically dropped out of the top quartile within three years, and 97% did so within six years. As market conditions change, different investment styles perform better at different stages of the economic cycle. This emphasises the point that investors should consider diversifying their allocations among managers with different, yet complementary, investment styles, rather than relying on a single manager to excel in all conditions.

An interesting point to note is that while concentrated markets can be risky, concentrated portfolios built using only very high conviction stocks, can be beneficial. The key difference here is skill in picking the right high conviction stocks, rather than concentrating your allocation on purely the largest companies in the market. A focused portfolio of around 20 high-conviction companies can yield better results because successful picks have a greater impact on overall performance. However, the key risk in this approach is the variability of manager performance – can they pick the best performing companies? Diversification can mitigate this risk by combining managers with complementary styles, balancing out performance fluctuations and maintaining potential upside. 

 

Source: Global equity index shown by MSCI ACWI as at 30 August 2024

The Noise

• The U.S. dollar is on track for its largest weekly gain since April, driven by safe-haven demand amid rising geopolitical tensions in the Middle East and anticipation of key U.S. jobs data. Investors are focused on the September non-farm payrolls report, in which nonfarm payrolls rose 254,000 in September compared with an estimate of 140,000 and the unemployment rate was 4.1% for the previous month, versus an estimate of 4.2%. This stronger-than-expected data could influence the Federal Reserve's future interest rate decisions. The dollar has strengthened against major currencies, with the Euro falling to a low since August 2015 of $1.0965.

• Oil prices are set for a 10% weekly rise due to escalating tensions in the Middle East, particularly concerns about potential disruptions to supply. The conflict, particularly the U.S.'s discussions about supporting Israeli strikes on Iran's oil infrastructure, has increased the risk of broader regional involvement. Despite the rise, gains were limited by the overall well-supplied global market. Brent crude futures rose by 1.4% to $78.71 a barrel. Investors remain cautious as geopolitical risks continue to influence the market outlook.

• The European Union is moving forward with a proposal to impose tariffs of up to 45% on Chinese electric vehicle (EV) imports, following a split vote on October 4, 2024. While 10 EU member states backed the tariffs, 5 voted against, and 12 abstained. Germany, Europe's largest car producer, opposed the move, citing concerns over its automotive industry's reliance on the Chinese market. These tariffs are intended to counter what the EU sees as unfair Chinese subsidies. However, negotiations with Beijing are ongoing, with the possibility of setting minimum sales prices as an alternative solution.

The Numbers

The Nuance

With less than a month to go until the Budget, the government has hinted about what to expect but we haven’t seen much in the way of policy specifics yet. The headlines have focused on the winter fuel payment as well as the prospect of higher taxes, including changes to capital gains tax and removal of non-domiciled tax status. These policies on their own are unlikely to dramatically influence the financial markets, but the direction of policies point to tighter fiscal policy from here.

The government appears committed to controlling and reducing the fiscal deficit. Chancellor Rachel Reeves has pledged to follow two key rules: 
1. The current budget must move into balance (i.e. no more deficit) such that all day-to-day costs are met by tax receipts.
2. National debt must be falling as a share of GDP by the fifth year of the forecast (defined by the OBR).  

The upcoming Budget could bring greater belt tightening, prompting markets to expect a weaker UK economy over the next year. This could also mean a faster pace of interest rate cuts by the Bank of England. We think this would likely support good performance from UK government bonds and push sterling lower.

Specifically, in the case of sterling, the currency has appreciated against the dollar quite significantly this year. However, a more substantial and rapid series of UK rate cuts relative to the US would be less supportive of sterling. In this scenario, domestic investors may favour holding higher-yielding US assets (such as US treasuries) to lower-yielding UK assets (like UK government debt), decreasing the demand for sterling relative to the dollar.