The meteoric rise of U.S. tech giants like Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla, fueled by a booming interest in artificial intelligence, has tilted the scales of Wall Street. This trend has brought both extraordinary gains and significant challenges, particularly for active fund managers struggling to maintain portfolio diversity and deliver differentiated performance.
The Heavyweight Effect: Tech’s Oversized Influence
These seven tech giants, part of the top 10 companies in the S&P 500, accounted for nearly half of the index’s gains in the year to October 2023. Their dominance has led to the most concentrated market weighting in 40 years, with the top 10 stocks now representing over 35% of the S&P 500’s total value, according to Bank of America research.
The first quarter of 2024 highlighted the influence of these tech stocks starkly. Without them, the S&P 500 fell by 5%, but with their inclusion, the index surged by 7.6%, as per JPMorgan data. Globally, these seven companies accounted for 12% of the MSCI World Index by June 2023, despite the index comprising nearly 1,400 stocks.
The Rise of Portfolio Correlation
The unprecedented dominance of tech giants has created a ripple effect across active funds, with many now behaving like passive index trackers. The concentrated market has left fund managers with fewer avenues for diversification, leading to tighter correlations between portfolios. This trend raises concerns about potential vulnerabilities in case of a market correction.
James Thomson, who manages Rathbones’ Global Opportunities Fund, acknowledges the anxiety this creates. “It’s a struggle for active funds to outperform in a concentrated market,” he notes, warning of the risks if these top stocks falter. A dramatic market correction could have outsized effects on portfolios heavily weighted toward these tech leaders.
The Broader Picture: Global Market Shrinkage
The challenges for active fund managers go beyond tech stocks. Globally, equity markets have been shrinking due to declining new listings and increasing merger and acquisition activity. This consolidation has amplified index concentration and further limited the flexibility of active managers to craft unique portfolios.
Joe Wiggins, investment research director for St. James’s Place, points to the “zeitgeist” effect driving this trend. The hype surrounding artificial intelligence has funneled more money into a narrow set of tech stocks, reinforcing market concentration. “Whether they are doing it deliberately or it’s an unconscious behavioral bias, more managers are investing in the [seven big tech] stocks,” he explains.
Pressures on Active Fund Managers
The growing correlation between active funds isn’t just about market conditions. Fund managers face external pressures, including investor expectations and compensation structures that often reward short-term performance. These incentives can push managers toward herd behavior, chasing winning stocks instead of maintaining diversified strategies.
Dan Brocklebank, head of UK at Orbis Investment, highlights the risks of such pressures. “This ripples through to the portfolio management, and this influence can be very powerful,” he notes, calling for better communication with investors about the importance of maintaining low fund correlations.
Strategies for Reducing Correlation Risks
Active managers have several tools at their disposal to mitigate the risks of high portfolio correlation:
- Equal-Weight Portfolios: Keeping all holdings at the same percentage within a portfolio reduces reliance on a few dominant stocks while still allowing exposure to market leaders.
- Top-Slicing Profits: Reinvesting gains from dominant stocks into underweighted equity opportunities helps diversify portfolios and manage concentration risks.
- Incentive Overhaul: Addressing corporate structures and aligning incentives with long-term diversification goals can empower managers to take contrarian positions when necessary.
Chris Mellor of Invesco advocates for an equal-weight approach as a way to navigate concentration and correlation bias while still achieving steady long-term performance.
Lessons from Energy Sector Trends
The current tech-dominated landscape is reminiscent of the energy sector’s dominance following Russia’s invasion of Ukraine in 2022. Back then, oil giants like Chevron, ExxonMobil, and BP outperformed, with their combined profits nearing $200 billion. Active funds heavily underexposed to these companies faced criticism for underperformance, mirroring the current challenges posed by tech stock concentration.
The parallels underscore the cyclical nature of market concentration and the importance of active strategies that balance short-term gains with long-term resilience.
Looking Ahead: Active Management in a Concentrated Market
The rise of tech giants and the ensuing portfolio correlation issues present a cautionary tale for fund managers and investors alike. As market concentration continues to grow, the need for innovative strategies to differentiate portfolios has never been greater.
For active managers to remain truly active, they must resist the pull of herd behavior, embrace diversification, and communicate their strategies effectively to stakeholders. Only then can they navigate the risks of a skewed market while still capturing opportunities for growth.
