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Equity

The Pitfalls of Concentrated Market Performance

An intentional, steadfast approach to diversification may help investors navigate the repercussions of narrow short-term market leadership trends.

By Brent Puff, Bernard Chua, CFA
03/05/2024

Key Takeaways

The dominant returns of the Magnificent Seven stocks in 2023 may have skewed investor portfolio risk/return profiles.

An active approach to security selection and asset allocation offers the potential to spread risk more evenly and manage it appropriately.

Consistent, long-term exposure to diverse areas of the market may have the potential to produce superior investment performance.

All investment performance, as the saying goes, is not created equal.

Sometimes, returns are widely dispersed across individual stocks, industries and sectors. In other periods, the performance dispersion is much narrower, with a select few stocks or areas of the market accounting for the lion’s share of the market’s return.

That’s what happened in 2023 when the so-called Magnificent Seven drove much of the global stock market’s gain. Investors in portfolios with heavy weights to these stocks undoubtedly benefited from their strong performance. On the other hand, the composition of that performance raises caution flags about their portfolios’ risk/return profiles.

Moreover, the performance advantage of being highly concentrated in these stocks could be temporary. Data spanning the past two decades confirms the performance advantage of consistent exposure to broad, diverse areas of the market benefits portfolios over the long term.

Given the heightened risk and security concentration accompanying 2023’s narrow leadership, we believe it may be time for global investors to reassess their allocations and exposure. As they do, portfolios targeting consistently diverse market exposure may warrant a closer look.

Magnificent Seven Set a New Standard for Narrow Market Performance

The history of equity markets is replete with periods in which a few stocks, industries or sectors dominate performance.

In 1900, for instance, railroads accounted for almost two-thirds of the U.S. stock market’s total value, a proportion that, by default, determined the overall market’s direction.1 A century later, soaring technology and wireless stocks pushed the Nasdaq Composite Index up 85.6% in 1999, the largest annual gain for any major U.S. stock index in history at that time.2

A little more than a decade later, in the wake of the global financial crisis of 2008-09, the initial “FANGs” began composing an outsized portion of U.S. equity market returns. The acronym described four stocks – Facebook, Amazon, Netflix and Google – standing at the intersection of a new digital, consumer, technological and communication era. Apple was added to the group in 2017, making the moniker FAANGs.

The FAANGs are part of today’s Magnificent Seven:

The FAANGs are part of today’s Magnificent Seven:

  • Apple Inc. – AAPL

  • Amazon.com – AMZN

  • Alphabet (Google) – GOOGL

  • Meta Platforms (Facebook) – META

  • Microsoft Corp. – MSFT

  • Nvidia – NVDA

  • Tesla – TSLA

These stocks now account for about a third of the S&P 500’s market weight – and all-time high – and 17% of the MSCI All Country World Index’s (ACWI) total market capitalization.3

Just how profoundly did the Magnificent Seven affect overall market returns? As shown in Figure 1, the S&P 500 gained more than 26% in 2023. However, if we exclude the Magnificent Seven from those returns, the remaining index constituents rose just under 14%. The Magnificent Seven, on the other hand, climbed more than 76%.

The sheer scope of that return contribution arguably set a new standard for “narrow leadership.” The Magnificent Seven have proven to be volatile, though. Their 2023 rally followed a 2022 in which they lost a combined 41% of their value, compared with a 12% decline for the rest of the S&P 500.4

Aside from considering whether investors ultimately benefit from the group’s current outsized market impact, the impact itself is undeniable. To wit: With their 2023 rally, Apple (up 49%) and Microsoft (up 58%) now compose almost one-seventh of the S&P 500’s market weight – the largest share for any two companies dating to at least 1980.5

Figure 1 | The Magnificent Seven Had an Overwhelming Impact on the S&P 500’s 2023 Results

S&P 500 vs S&P 500 “Magnificent Seven” – 2023 Total Return
Magnificent 7 chart comparing the cumulative returns of the Magnificent 7 stocks to the S&P 500 Index and the S&P 500 excluding the Magnificent 7 tech companies.

Data from 12/31/2022 – 12/31/2023. Source: FactSet. The Magnificent 7 includes the following tickers: AAPL, AMZN, GOOGL, GOOG, MSFT, META, NVDA and TSLA. Past performance is no guarantee of future results.

Are Portfolios Overexposed to the Magnificent Seven?

While the Magnificent Seven took flight in 2023, the average S&P 500 stock advanced by a more modest 14%. Because of the former’s outperformance, the average stock now plays a smaller role in the market’s overall return – at least for now – while the Magnificent Seven’s role has grown markedly.

The sheer outperformance of these stocks has increased their heft in the global investment marketplace. As a result, their rising capitalization may have significantly altered intended investment allocations in many portfolios.

Consequently, some investors now may have considerably more exposure to narrow portions of the technology sector than they did just 6-12 months ago. That’s particularly true for investors relying on exchange-traded and index funds tracking market weights of popular global indices. Such exposure may compromise investment portfolios in terms of risk management and potential returns.

Narrow Leadership May Skew Global Allocations

Each Magnificent Seven company is based in the U.S., with an investment impact that extends beyond the S&P 500 to global investment portfolios designed to provide worldwide equity exposure.

The MSCI ACWI Index is one of the most recognized measures of the entire global equity market, with a market capitalization of $65 trillion covering 85% of the world’s investable universe.6

With the Magnificent Seven’s 2023 surge, their combined weighting in that global index now surpasses stocks from Japan, France, the U.K. and China combined.7 As a result, investors using the index as a proxy for a global investment portfolio now have more exposure to the Magnificent Seven than they do to three leading developed markets and the world’s second-largest economy.

So, it’s reasonable to question whether such portfolios exhibit the broad global exposure investors intend. And if the answer is no, should they select portfolios with more consistent exposure across the global sector and industry spectrum? Portfolios that – regardless of recent narrow leadership – do not tilt to fewer and fewer areas of the market and thereby do not have a corresponding reduction in exposure to an increasingly wide portion of the remaining investment universe.

Performance Data Supports a Diversified Approach

The Magnificent Seven’s run, as we’ve shown, rendered the S&P 500’s performance top-heavy in 2023 – more than every year but one since the U.S. monetary system went off the gold standard more than 50 years ago.

The equal-weight version of the S&P 500, in which each of the index’s constituents maintain the same weight regardless of market appreciation, underperformed the S&P 500 by 14% in 2023.8 The reason: The capitalization-weighted index benefited primarily from the Magnificent Seven’s increasing weight, reflecting the group’s substantial valuation gain.

Dating to 1971, only once – 1998 – did the equal-weight version of the index underperform the market-cap version by more. That year’s underperformance equaled 16.4%.9

History doesn’t favor a market-cap weighting approach, however. Instead, investors may benefit from a more diverse strategy.

Aside from 1998 and 2023, the traditional market-cap version of the S&P 500 has not outperformed the equal-weight version of the index in any one year by more than 10%. Conversely, the equal-weight index has outperformed by a margin of 10% or more on seven occasions. Moreover, returns for the equal-weight index surpassed the market-cap version in 28 of the last 53 years – more than half the time.10 See Figure 2.

Figure 2 | The Equal-Weighted Index Outperformed More Often and By a Wider Margin

Bar chart showing the difference in Total Return between the S&P 500 Equal-Weighted Index and the S&P 500 Capitalization-Weighted Index from 1971 through 2023. Cap Weighted Index outperformed in 2023.

Data from 1/1/1971 – 12/31/2023. Source: Morningstar Direct. Total return represented in USD. Past performance is no guarantee of future results.

Can Active Managers Mitigate Concentration Risk?

It’s important to assess the investment outcomes of market-cap agnostic portfolios that maintain steadfast, consistent exposure to diverse areas of the global market. Comparing these outcomes with portfolios whose position weights vary based on the market appreciation (or depreciation) can offer meaningful insight for investors.

We do this by employing holdings-based data to construct equal-weight portfolios for the MSCI ACWI for the past 20 years. These two decades encompass normal market cycles and periods of unforeseen market upheaval (e.g., global financial crisis, COVID-19 pandemic), giving us a solid read on long-term impacts.

We compared the equal-weight investment performance, on a total return and risk-adjusted basis, with the regular market-cap MSCI ACWI Index for the same period.

Our findings indicate that, over time, investors may benefit from consistent, diverse exposure throughout the market cycle – the type of exposure that an equal-weight portfolio or consistently diverse active investment approach might offer:

  • In the 20 years ended September 30, 2023, the MSCI ACWI equal-weight portfolio produced a cumulative return of 446.49%, compared with 342.31% for the market-cap MSCI ACWI Index.

    • The equal-weighted portfolio outperformed by 30%. That would have produced $4.5 million from an initial $10,000 investment, exceeding the return from an initial investment in the cap-weighted index by more than $1 million.

  • On an annualized basis, the equal-weight portfolio outperformed the market-cap index by 55 bps (8.31% vs 7.76%).

  • On a risk-adjusted basis, the equal-weight portfolio produced a higher annualized Sharpe Ratio (-0.37 vs -0.48) despite showing marginally higher annualized volatility.

  • The equal-weight portfolio posted higher returns than the market-cap index in 133 of 240 months during the 20-year time frame – 55% of the time.

  • The equal-weight portfolio also outperformed the market-cap index in 55% of rolling 10-year periods in the 20-year time frame.11

Optimizing Investment Strategies for Diverse Market Conditions

Long-term investors targeting global exposure don’t have to invest solely in equal-weight portfolios to attain the type of consistent market diversity that offers the potential benefits we’ve discussed. Active managers dedicated to such diversity can provide similar exposure – most likely with a more risk-aware approach.

Meanwhile, it’s instructive to again consider how rising risk is a key byproduct of increased portfolio concentration wrought by narrow market leadership.

Aside from the higher price-to-earnings multiples that market leaders usually exhibit, history shows their leadership – and their impact on the market ebbs and flows.

The late 1990s are a prime example. Soaring technology stocks drove U.S. stocks to all-time highs, with the market-cap S&P 500 outperforming the equal-weight version by the biggest margin ever in 1998. Just two years later, though, the equal-weight S&P 500 outperformed the market-cap version by the second-widest margin ever as tech stocks collapsed.12

Of course, the Magnificent Seven have far more established revenue and earnings streams than many of the dot.com stocks that inflated the 1990s stock market bubble. Nonetheless, their recent leadership dominance raises the specter of concentration risk.

Strategies for Diversified Global Investments Amid Narrow Market Leadership

Powerful innovative forces have helped turn the Magnificent Seven into economic engines with the potential to shape society for decades to come. Nevertheless, the sheer scope of their outsized market returns may have pushed their exposure to increasingly questionable levels in many portfolios.

Actively managed portfolios can guard against such unintended risks. Via security selection and asset allocation, they can spread risk more evenly and manage it more appropriately.

This reality highlights a key advantage of actively managed portfolios compared with their passive, index-replicating counterparts (and index-hugging active strategies). However, it also makes them vulnerable to short-term underperformance during periods of narrow leadership.

Data shows that, over time, investors in global portfolios benefit from a consistent allocation to diverse areas of the market. Those benefits accrue from both risk and return perspectives.

That’s why investors in global portfolios maintaining a more diversified approach should consider remaining patient, particularly given the world’s precarious economic position and geopolitical uncertainty. Furthermore, on the heels of narrow returns leadership that markets recently have experienced, we believe that investors who haven’t incorporated such an approach may want to reconsider.

Authors
Brent Puff
Brent Puff

Vice President

Senior Portfolio Manager

Bernard Chua, CFA
Bernard Chua, CFA

Vice President

Senior Client Portfolio Manager

Explore Our Global Concentrated Growth Capabilities

Elroy Dimson, Paul Marsh, and Mike Staunton, “Credit Suisse Global Investment Returns Yearbook 2017 – Summary Edition,” February 2017.

Tom Petruno, “1999 Goes Into the Record Book on Wall Street,” Los Angeles Times, January 1, 2000.

FactSet and American Century Investments.

The Economist, “Forget the S&P 500. Pay attention to the S&P 493,” November 8, 2023.

Charlie Bilello, “This Week in Charts,” Bilello Blog, December 13, 2023.

MSCI ACWI Index Factsheet, December 29, 2023.

Hardika Singh, “It’s the Magnificent Seven’s Market. The Other Stocks Are Just Living in It,” Wall Street Journal, December 17, 2023.

FactSet.

Morningstar Direct and American Century Investments.

Morningstar Direct and American Century Investments.

FactSet and American Century Investments.

FactSet and American Century Investments.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

The information is not intended as a personalized recommendation or fiduciary advice and should not be relied upon for, investment, accounting, legal or tax advice.