Risky Business

We have written before about the risks to passive investors when indexes become overly concentrated. Investors may think that they are well diversified when their index fund holds 500 or even 1,000 different stocks, but there are times that market capitalization (i.e. weighted by company size) funds can pose unexpected risks. When a small group of stocks or a particular sector of the market outperforms the rest of the market, that cadre becomes a larger portion of the overall index. Over the years different groups of stocks have grown in size inside these funds. It is not unheard of that upwards of 30%, 40%, or more of an index is comprised of a few companies. The following is my imagined conversation that may have happened in a lot of consulting shops over the past decade.

Analyst 1: “Ugh, most of our active large cap growth managers are getting crushed by the index. Again.”

Analyst 2: “Want me to find you a manager with more than 30% of its portfolio in three holdings? How would our investment committee or clients like that?”

Analyst 1: “Right. I almost forgot that Microsoft was nearly 12% of the Russell 1000 Growth, Apple is 10%, and Nvidia is almost 8%.¹”

Analyst 2: “Yep. The rich get richer.”

The Russell 1000 Growth Index has been a juggernaut, performing in the top 4th percentile against active managers in the space over the past decade.² During this time, the largest companies have become an ever-larger part of the index as their market dominance has increased.

When looking at a portfolio, there are various measures of concentration risk. One such measure is Issue Diversification which measures how many stocks make up 50% of a portfolio. In the chart below, you can see that the largest 72 stocks compose 50% of the Russell 1000 Value Index whereas only 9 stocks account for half of the weighting of the Russell 1000 Growth Index.

The Value Index has been more stable, over time, in terms of diversification whereas the Growth Index has had larger swings and has recently eclipsed 30-year lows by this measure. What this says to us is that there may be risks that investors in passive products are taking that they may not be aware of. As a matter of fact, the last time the index was so concentrated was during the Tech Bubble of the late 1990s. As a word of warning, in 2000, during the initial phase of the market meltdown, the index underperformed 82% of active managers.³

We are not suggesting that these large companies face imminent doom. In fact, this Independent Insights is an update from an article we penned several years ago, and the small handful of mega-stock names have continued to power the market forward. What we are saying is that investors need to understand that they may not be as diversified as they think they are.

¹ As of 03/05/2024, Frank Russell
² Through 12/31/2023 compared to the Callan Associates, Inc.’s Large Cap Growth Mutual Fund Universe
³ Russell 1000 Growth compared to Callan Associates, Inc.’s Large Cap Growth Mutual Fund Universe for calendar year 2000

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