What does a highly concentrated market mean for investors?

Watching the Tour De France unfold this year has been hugely enjoyable with two very well-matched adversaries for the Yellow Jersey, Slovenia’s Tadej Pogacar and defending champion Jonas Vingegaard from Denmark.

Typically, the race favourites spend much of their time in the ‘peloton’, the mass of riders that hurtle across the French countryside, aerodynamically protecting one another in order to save energy for the crucial culmination of each stage. Those that decide to initially set off at an even faster pace in search of a win do sometimes escape to victory, but usually the odds are against them as the pace of the peloton ratchets up and they are eventually reined in. Ultimately, the winner on the day often comes from the pack that has had an easy ride for much of the route.

There is a useful investing analogy here. Taking extra risks to try and outpace market returns can sometimes pay off, but being in a ’peloton’ of broad market investments can effortlessly get you most of the way without the risk that you get things terribly wrong and you fall significantly behind. It’s why investors who prioritise diverse, passive investments in a streamlined and low-cost portfolio often enjoy good results without huge effort. Such investments simply follow the market index rather than try and beat it.

That said, just as the specialist cyclists seeking stage victories can get their timing right and claim glory, an active and selective investment approach can win out on its day. Opportunistic investors, or those willing to take a contrarian approach, can put distance between themselves and others.

It hasn’t felt this way in recent years, though, as some of the world’s largest companies have increasingly overshadowed virtually everything else, resulting in something called ‘high market concentration’.

This is when a small collection of stocks dominate returns from major market indices, as we’ve seen in recent years from the so-called ‘magnificent seven’ (Apple, Microsoft, Nvidia, Tesla, Alphabet, Amazon and Meta). Some are questioning whether this tight leadership is a mini bubble.

Benefits and risks of investing in the ‘magnificent seven’

High valuations are certainly cause for concern, but there are also logical reasons why investors have corralled into this small group of stocks. For instance, they are not immediately seeing the negative effects of higher interest rates or an increasingly fatigued consumer. The magnificent seven are also seen as offering growth in a low growth world, and a number of them stand to benefit from advances in AI, a narrative that has captured investors’ imaginations.

The concentration of returns among the biggest tech companies – which dominate the list of the world’s most highly valued companies – has made things challenging for active fund managers who tend to avoid excessive risk that stems from an over concentration in certain stocks or a particular sector or area of the market.

These companies are also mostly expensively valued in relation to their earnings, so they could be more vulnerable to any disappointing news surrounding their profitability or outlook. They would therefore tend to be avoided by managers taking a ‘value’ approach of seeking out stocks that have limited downside because they trade at levels close to, or below, what they would consider to be their intrinsic value.

Yet for the past decade, simply following the index has been the best strategy, certainly on a global basis or when targeting the US market. Staying sheltered in the peloton has been the right strategy. However, risks could be building.

Global and particularly US indices such as the S&P 500 have become top heavy with just two stocks, Apple and Microsoft, accounting for just under 10% of all global stock market value. Amazingly, Apple is valued more than all of the shares in the UK stock market added together. Global investors are therefore increasingly reliant on a relatively small number of businesses carrying on delivering. There is a risk the pace of the market peloton becomes pedestrian going forward if these race favourites disappoint.

Perhaps then the potential rewards for a differentiated approach are growing, and that cheaper stocks and sectors offer investors the opportunity of a podium finish in the next market stage. We don’t know for sure, but there is a growing risk that the market peloton isn’t as safe a place to be when it is being pulled along by such a small band of riders doing all the work.

Investors who feel vulnerable to this could seek out active funds that have less concentration in the top names. Alternatively, ‘equally-weighted’ passive funds offer exposure to all or most of the shares in an index but in uniform-sized chunks, typically rebalanced quarterly.