How investment success can increase portfolio risk

The digital revolution has provided one of the most significant investment themes in recent decades – underpinned by the fact that the pace of technological change seems to be accelerating. Gains in the so-called Magnificent Seven technology mega-cap companies since the start of last year have been significant drivers of equity markets following the stock market slide in 2022.

The reason for this is clear. Many of the companies are driving the rise of artificial intelligence (AI) – and excitement about the future of this technology has underpinned the gains that have driven the S&P 500 to record highs. However, this success also presents an investment risk, as portfolios get more exposed to one specific area of the stock market due to its rapid growth.

Because exchange-traded funds (ETFs) are generally cheaper to run than active funds, their popularity amongst investors has risen significantly. ETFs are a type of collective investment that provide access to a wide range of markets by tracking an index or a basket of shares that are related to a particular theme.

This brings the risk that – when individual shareholdings and exposure through ETF is combined – there is too much exposure to a particular sector should market sentiment on its prospects turn negative.

The soaring market value of Magnificent Seven companies means they now have a significant weighting in equity-market indices – and the passive funds that track them.

The chart indicates just how large the technology sector has become when it comes to major stock market indices.

It shows the combined weight of the Magnificent Seven equities in some wellknown large-market-cap index tracking ETFs and funds, as well as the US indices. It also shows the dominance of the top ten holdings. One of the major ways of managing equity-market risk is by diversification.

There is a possibility that such crossholdings could leave a portfolio overexposed should there be a downturn in stock markets generally or sentiment surrounding the sector. This means it is important to understand exactly how much exposure there is to an individual company or sector in an investment portfolio as a whole.

It is likely there will be a holding of the individual equity plus additional exposure via any active funds or index tracking ETFs, especially since the weighting of these companies in index tracker funds continues to rise.

Of course, market dominance is not necessarily unique and is only a problem if it is not supported by fundamentals. Clearly, the digital revolution will continue – and the development of the sector will be in place as a major investment theme and opportunity for quite some time to come. But, as with any investment, it is important to be aware that no area of the stock market is risk free – and markets can take a downwards lurch for a wide range of reasons. There are many factors to be considered, including global macroeconomic news, government policy changes and consumer sentiment.

A good example of this was seen in 2022, when the start of the rising interest rate cycle resulted in a slump in the technology sector. Tech companies and startups relied on the cheap money that near zero interest rates provided. Massive companies, such as Uber, were still unprofitable and many sector players have relied on investment and financing to invest for growth.

If crossholdings in a portfolio are not taken into account, a portfolio may be overexposed to one area of the market. This increases risk by adding a turbocharge to portfolio losses in any sector downturn, so the risk this presents must be continually monitored.