The concentration risk in equity markets is growing as US megacap technology companies continue to attract capital. Diversification, often seen as the only «free lunch» in investing, risks coming at a cost.
During a November meeting, a member of the multi-asset investment team at Aegon Asset Management introduced the topic of “market concentration” with a chart showing the sector dominance of the S&P500 over a 35-year period. Portfolio manager Jordy Hermanns commented: “We immediately noticed that most of the market concentration originates from the technology sector, led by the ‘Magnificent Seven’ stocks.”
The current level of market concentration—where the ten largest companies account for 37.5 percent of the benchmark—has only been seen once in the past 35 years, during the bursting of the dotcom bubble in 2001. Despite the similarities, such as high valuations in the technology sector, Hermanns cautions against drawing a direct parallel: “In 2001, the market was inflated by speculative valuations based on hopeful expectations. Today’s tech companies deliver solid results, although some degree of bubble formation remains.”
Largest sector in the S&P500
For Aegon, this was sufficient reason to cash in some profits from their equity portfolio. The freed-up liquidity was used to increase their allocation to listed real estate. Within their equity allocation, however, there was no reason to make significant changes. “Tech stocks can continue to rise surprisingly for some time, but we are closely monitoring the concentration and exploring smart ways to manage the risks.”
Tech monopolies
With the abundance of monopolies in the technology sector, it is unsurprising that this sector drives market concentration. This is inherent in an industry where companies aim to capture the largest possible market share in the shortest time. “Once companies achieve a monopoly position, it becomes easier for them to maximise profits. Due to economies of scale, it is challenging for new entrants to break into the market,” said Hermanns.
The increased concentration in US tech companies has pushed the US market’s share in the MSCI ACWI to 67 percent. The exceptional performance of US tech megacaps has come at the expense of diversification, as evidenced by the Equity Diversification Index (shown below). This index measures diversification within the global equity universe and is currently at 113—the lowest point in 35 years. The lower the index, the less diversification exists in the equity market.
Equity Diversification Index (MSCI ACWI)
Saxo Nederland warns on its website that the US equity market, as measured by the Herfindahl-Hirschman Index (HHI), is now twice as concentrated as it was during the peak of the dotcom bubble in 2000. The HHI is a measure of market concentration, calculated by summing the squares of the market shares of all companies in a market. A higher HHI value indicates less competition.
The bank predicts that concentration will peak, creating a vulnerability for equity markets. It advises retail investors to protect their portfolios by diversifying more effectively.
US investors vs European savers
The tech companies’ pursuit of market share is one reason for the current high market concentration, while the “home bias” of US investors is another. Additionally, Americans invest far more than the savings-focused Europeans.
Hermanns points out that Americans primarily invest in their domestic market, showing little interest in European equities. Similarly, Europeans prefer investing in their home markets and, according to Hermanns, have made a “costly mistake” by missing the tech rally. While US equities represent nearly 70 percent of the global equity market, Dutch investors allocate only 18 percent of their equity portfolios to the US, according to the Dutch central bank (DNB). Although this percentage has increased in recent years, it remains significantly below the 70 percent threshold.