Some advisors see concentration risk as a problem and are looking beyond large caps as interest rates start to come down.primeimages/iStockPhoto / Getty Images
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The Magnificent Seven stocks have had a magnificent run that may be running out of steam, with many investors seeing interest rate cuts ahead as the U.S. economy slows.
Rather than a “great rotation,” whereby the U.S. equity growth broadens amid lower borrowing costs, some advisors are taking more defensive positions amid fears of a recession.
“You always wonder how long this strong run can keep going,” says Sean Mikucki, an investment advisor with iA Private Wealth Inc. in Winnipeg.
Exposure to the Magnificent Seven stocks (Apple Inc. AAPL-Q, Nvidia Corp. NVDA-Q, Amazon.com Inc. AMZN-Q, Microsoft Corp. MSFT-Q, Alphabet Inc. GOOG-Q, Meta Platforms Inc. META-Q and Tesla Inc. TSLA-Q, although the latter is now the 12th largest company in the S&P 500) has been on the minds of clients for months, Mr. Mikucki says.
“Some like the idea of capping [exposure], and others say, ‘Let it rip,’” he says of those comfortable with market-cap weighted exposure.
After all, mega-cap tech names have generated about 60 per cent of the S&P 500′s returns since the start of 2023, according to a recent J.P. Morgan Wealth Management note.
Yet, that performance is also a reason for paring back those positions, Mr. Mikucki says.
The ongoing risk is increasingly hard to ignore for many advisors, given the S&P 500′s top six holdings make up around 30 per cent of the index’s US$47-trillion market cap as of late August.
That’s led many asset managers to predict coming headwinds for these companies, while cyclicals such as financials could see growth if interest rates decline and revive a slowing economy.
These concerns were a key driver behind the recent launch of a suite of exchange-traded funds from BlackRock Inc.
“We have been hearing from investors that they want tools to manage overconcentration,” says Hail Yang, director of iShares Canada product consulting for Blackrock Inc.
Those investors include Canadian advisors, who know all too well about overconcentration risk, he adds. “This is so intuitive because, as Canadians, we’ve lived through the likes of Nortel [Networks Corp.].”
The new iShares S&P 500 3% Capped Index ETF XUSC-T (along with U.S.-dollar and Canadian-dollar hedged versions) launched on the Toronto Stock Exchange in July. The fund caps all stocks on the S&P 500 at 3 per cent of the index’s cap weight. It then redistributes the weighting in a given stock above that threshold among the other stocks across the index in proportion to their weightings, Mr. Yang explains.
Yet, the ETF still reflects the broad U.S. market more than an equal-cap-weighted fund does, Mr. Yang argues. “All the options we saw … took you so far away from the actual U.S. equity benchmark that you ended up with this portfolio that didn’t reflect the real economy.”
Blackrock is not the only asset manager offering strategies to counter overconcentration.
“The message we tell our investors is that they made good money in large caps and now is the time to broaden into small- and mid-caps,” says Aman Budhwar, a portfolio manager with PenderFund Capital Management Ltd. in Mississauga.
PenderFund is in the midst of launching a U.S. small- and mid-cap equity fund, Mr. Budhwar says, to provide broader exposure to the U.S. economy.
He points to how the S&P 500 is too concentrated in information technology, which exceeds 30 per cent of the index’s market-cap weight.
In contrast, the S&P MidCap 400 index’s largest sector exposure is industrials at about 22 per cent, while technology makes up only about 9 per cent.
Should the U.S. Federal Reserve Board start cutting rates later this month, this will create a “favourable” environment for small- and mid-caps, Mr. Budhwar says, “because most of these companies are domestically oriented and generally have more debt.”
Recession risks aside, which would affect all equities negatively, small- and mid-caps offer deep value opportunities for active managers without the overarching risk of overvaluation and extreme overconcentration of large caps, says Greg Dean, founder and lead investor at Langdon Equity Partners Ltd., which runs Langdon Global Smaller Companies Fund.
“What is truly risky today is that everybody owns the same stuff,” he says. When investors get spooked, as they have recently, large companies see wild downside swings.
Although large caps have done well and could do even better, it’s just as likely the S&P 500 goes sideways for the next few years while small- and mid-caps see steadier growth, Mr. Dean says. One reason is that, until the past five years or so, small- and mid-caps have historically outperformed large-cap stocks.
The S&P 500 has an annualized return of 14.3 per cent during the past five years compared to 10.8 per cent for the S&P MidCap 400 and 9.3 per cent for the S&P SmallCap 600. But from 1994 to 2021, the S&P 500′s historical return was 11.2 per cent, a report from S&P Global shows, while the mid-cap index returned 13.1 per cent and the small-cap index returned 12.4 per cent.
Yet, the recent outperformance of large-caps has convinced many investors “that this time it’s different,” Mr. Dean says. That creates opportunities in underinvested parts of the market – such as small- and mid-caps that actually make up 90 per cent of all U.S.-listed equities – for fundamental value investors.
“It just gives us a great backdrop to invest because everybody is chasing the same half-dozen companies,” he says.
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