CashNews.co
Shares in US technology giants have risen so rapidly this year, driven by an artificial intelligence frenzy, that their index weighting has skewed Wall Street’s overall performance — and prompted investors to run remarkably similar portfolios.
Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — which are among the biggest 10 companies on the S&P 500 — have accounted for about half the bellwether index’s gains in the year to October.
This influence means that active fund correlation, a measure of how similarly funds perform, has tightened considerably.
This current situation mirrors that with the five biggest energy groups in the aftermath of Russia’s invasion of Ukraine in 2022. Back then, Chevron, ExxonMobil, BP, Shell, and TotalEnergies all outperformed as a result of the war, amassing total profits of nearly $200bn in the year. Fund managers with little exposure to oil majors at the time were caught in the crosshairs as their boards and investors demanded reasons for their underperformance.
Some content could not load. Check your internet connection or browser settings.
James Thomson, who manages the equity-based Global Opportunities Fund at Rathbones Group, one of the largest listed wealth managers in the UK, says the issue with tech-stock correlation is a “source of anxiety”.
“It’s a struggle for active funds to outperform in a concentrated market, where the returns are coming from a small number of stocks with a high index weighting,” he says.
In the US, today, the top 10 stocks of the S&P 500 index make up more than 35 per cent of the entire benchmark — the most concentrated weighting in at least 40 years, according to Bank of America research. And the influence of the seven big tech stocks was laid bare in the first quarter of 2024 when the index fell 5 per cent without them but, including them, gained 7.6 per cent, according to JPMorgan data.
Globally, at the end of June, the seven accounted for 12 per cent of the market value of the MSCI World Index, which contains about 1,397 stocks in total.
This means many actively-managed global equity funds are behaving like index trackers. Supposedly diverse managed portfolios and discretionary managed funds are behaving similarly, with little to differentiate themselves from one another.
As a result, more investors are now exposed to the danger of a correction, which would hit all the portfolios exposed to the top 10 stocks particularly hard. “They’re marching ever-higher up the stairs,” Thomson says. “But, if there’s an air pocket or even a normalisation, they’ll take the elevator straight down.”
For investors, such close correlation between active funds means a balance has to be struck between performance-chasing and bottom-racing. Shunning the outperformers will hurt in the short term but investing at the wrong time will bring long-term underperformance.
Given these risks, why are so many active funds behaving in this copycat fashion? According to Joe Wiggins, investment research director for St James’s Place, the increasingly concentrated nature of stock markets is giving them less flexibility.
Globally, new listings have dwindled since the pandemic, while merger and acquisition activity has helped to shrink equity markets while, at the same time, creating corporate giants. This increases index concentration, and gives active fund managers fewer opportunities to create portfolios that are significantly different to passive (or tracker) funds.
On top of that, there is the “zeitgeist” effect, whereby certain narratives change the overall market dynamic — such as the current obsession with artificial intelligence. More money is piled into these stocks, boosting their market capitalisation and increasing sector concentration.
“It can be hard to be a contrarian when narrow sectors and themes are leading the market,” says Wiggins. “Whether they are doing it deliberately, or it’s an unconscious behavioural bias, more managers are investing in the [seven big tech] stocks.”
Conflicts of interest can also come into play. When a fund’s investors and its board demand quarter-to-quarter growth, and the fund manager’s pay is at stake, it can be difficult not to chase winning stocks and, instead, take a contrarian view.
Dan Brocklebank, head of UK at Orbis Investment, warns that “this ripples through to the portfolio management and this influence can be very powerful”, resulting in more correlation between funds.
Communication is important, Brocklebank says. When he explains to investors why Orbis aims to keep fund correlations low, they are prepared to stay the course.
“There’s a danger in creating perverse incentives that mean active managers do not steer away from what other people are doing,” says Wiggins.
How, then, can active managers make sure they are diversified enough to avoid a correlation problem?
Chris Mellor, head of Emea ETF equity product management at Invesco, advocates for an equal-weight approach — keeping all holdings at the same percentage within a portfolio — as a means of navigating concentration and correlation bias.
This can mitigate the risks that high correlation brings, while still gaining from a small exposure to market favourites — leading to good long-term performance.
Alternatively, “top-slicing” the profits from the biggest seven tech stocks, and reinvesting them into other equity opportunities, can avoid the concentration problem.
For Brocklebank, corporate structures and incentives must also be addressed, allowing managers to have conviction in their holdings. Only then can active managers be truly active.