Buying a fund or ETF that tracks the performance of the S&P 500 and sitting tight has been a winning strategy in US equities over the past decade or so. ‘Passive’ funds have delivered excellent returns by being most exposed to the biggest companies. For ‘active’ managers, who attempt to beat the stock market index, the North America sector has been a notorious graveyard, though. In 2020, large cap US funds recorded their 11th consecutive year where the majority of active managers (60% in 2020) lagged the S&P 500.
Will a traditional passive strategy be such a fruitful one in the future? Will the big continue to get bigger at a faster rate than the average company? We don’t profess to know the answer to this. We have long felt that the efficiency of the world’s most analysed stock market makes passive investing a particularly strong option for this market – even before the handicap of additional management fees for active strategies. Yet we do also believe risks could be building because of the concentration of the US market towards a handful of companies.
Winners from disruption brings ‘concentration’ risk
The disruption of Covid-19 lockdowns resulted in a quickening and broadening of the digital revolution and presented a clearer view of how the world will further integrate technology into daily life. This has benefitted technology giants and the sector in general. Microsoft, Amazon, Google, Facebook, Apple and others are the ‘blue chips’ of the current era with very strong market positions. Valuations may therefore be justified, but investors do also need to be aware of the dangers of more ‘lopsided’ portfolios.
The risk of a single company is greater than the risk of a number of stocks. The theory goes that if we own the market, we eliminate ‘non-systematic’ risk and are left only with ‘systematic risk’. Systematic risk is the risk of the overall stock market, which cannot be diversified away. However, if a small number of companies come to dominate an index then it poses a challenge for active managers trying to effectively diversify portfolios, and it can introduce greater non-systemic, or specific company, risk to passively-constructed portfolios.
Mega-cap technology companies are unlikely to be immune to economic downturns, changes in consumer preference or indeed regulatory developments.
Any capitalisation-weighted index such as the US S&P 500 or the FTSE 100 in the UK explicitly links the weight of a holding to its price, so the bigger (and potentially more expensive) a stock gets, the bigger its weight in a tracking portfolio. Today, the ten largest names in the S&P 500 index make up nearly 30% of its market capitalisation, up from just 18% five years ago. The top five are approaching 25% of the index.
Mega-cap technology companies are unlikely to be immune to economic downturns, changes in consumer preference or indeed regulatory developments. Unless they are, as some seem to believe, then investors could be putting too many eggs in too few baskets. Should momentum reverse then it might leave them exposed.
The Chinese experience
Although a different case entirely, what has played out in Asian markets over the past year is an example of how concentrated indices can be dangerous.
The top ten names of the MSCI Emerging Markets Index, representing around 1,400 companies, made up just 24% of market capitalisation in 2018. They then reached 35% last year with the inexorable rise of the Chinese technology ecosystem in the form of internet stocks Alibaba, Tencent and JD.com. In November 2020, Alibaba peaked at nearly 9% of the benchmark only to lose nearly half of its value in the subsequent months. Tencent and JD.com peaked in the first two months of 2021 and have suffered sizeable falls since. The collective impact of these three shares has been the main reason why the benchmark has struggled over the past year, and it has had a huge impact on passive approaches in emerging markets or China specifically.
There is a comfort in knowing, irrespective of market performance, that the low-cost approach of size-weighted tracker funds have a great chance of beating active managers in well-studied markets with few anomalies. However, the ‘silent risk’ of extreme concentration within some indices needs to be considered.
Relative to the size and importance of the US market in investment portfolios we have few high-conviction actively managed US fund ideas. It stands to reason that we have more options in areas where active management has had a better chance of delivering outperformance.
We are also conscious that the US market is far from cheap in a historical context. The largest companies within the S&P 500 are trading at more expensive valuations than smaller companies, and some investors might feel uncomfortable about buying the S&P 500 at a price to earnings multiple above 30. This is in the top 5% of the highest multiples seen for the market since 1900. Historically, long-term returns have been inversely related to the entry multiple.
There are two main strategies to counter this valuation risk alongside the risk of over concentration in mega-cap tech: Use an equal-weighted rather than market capitalisation-weighted passive fund, or invest with an active fund manager sensitive to valuations and who adjusts their portfolio accordingly.
Passive: X trackers S&P 500 Equal Weight UCITS ETF
X trackers S&P 500 Equal Weight UCITS ETF tracks the same number of holdings as a standard S&P 500 ETF but it weights the components equally – at approximately 0.2% presently – rather than by size based on relative market capitalisations. Holdings are rebalanced to equal weighting on a quarterly basis.
If investors are unsure about ‘big tech’ and current sector weights then moving to an equal weight strategy that places more emphasis on areas such as industrials, real estate, materials and utilities may be a consideration. Broadly, the approach tilts towards cheaper ‘value’ stocks and away from more expensive ‘growth’ stocks.
Charges are a fair bit higher for this product than the cheapest standard S&P 500 ETFs with an Ongoing Charges Figure (OCF) of 0.25% compared to 0.07% for the Vanguard S&P 500 UCITS ETF for instance, but it could be worth considering by those wishing to gain exposure to US markets using a passive strategy with a flatter exposure at a company and a sector level.
Active: Premier Miton US Opportunities
We think a genuinely active approach in the US can still add value above low-cost trackers given the premium valuation placed on the market. An attraction of the Premier Miton US Opportunities Fund is its ability to search for opportunities from the small to the very large in terms of company size and the flexibility with which the portfolio is managed.
The managers’ approach centres on identifying good-quality companies and paying appropriate valuations, described as ‘cash machines surrounded by barbed wire’. The managers are not wedded to ‘growth’ or ‘value’ stocks, preferring to take a more nimble and pragmatic approach, although the type of businesses they favour will tend to trade at a slight valuation premium to the market at times. We believe the fund has the ability to outperform its peers and the index in a variety of market conditions.
Performance since the 2013 launch has been good, achieved through a broad cross section of the portfolio, and beating most peers – though past performance is not a guide to the future. Expensive large cap technology names getting even more expensive has been a strong headwind, but good stock selection further down the market cap spectrum has compensated for this. The strategy can be expected to underperform if the ‘mega caps’, notably the technology cohort, lead smaller and medium-sized companies, though the managers’ sector positioning will be flexed over time depending on the opportunities they can uncover.
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