As a narrow group of stocks dominate global equity indices, we believe investors would do well to favour active managers with flexible mandates.

Index concentration is becoming a bigger issue for investors – and a potential trap for those who rely on index funds to generate equity returns.

Start with the S&P 500 Index, a leading barometer of US stocks. The 10 largest stocks in that index comprise 31% of it.1 Investing in the S&P 500 Index is essentially a bet on a narrow group of technology companies.

In Australia, the S&P/ASX 200 Index is even more concentrated. Its top-10 constituents comprise 47% of the index.2 Investing in the ASX 200 is largely a bet on the big-four banks and a handful of big resource stocks.  

Remarkably, half of the Australian sharemarket’s total dividend now comes from just eight stocks.3 Investors content with earning the market dividend yield are relying on a small group of stocks to deliver much of it. 

Index concentration continues to grow. The top-10 stocks in the Russell 1000 Growth Index, which measures large-cap US growth stocks, comprised 53% of that index in mid-2023. A decade ago, the figure was closer to 20%.4 

This concentration poses several investment risks. The first is valuation. As index concentration increases, performance leadership narrows. That was true of the S&P 500 Index when its seven largest tech stocks were responsible for most of its gains in the first half of 2023. 

In our experience, a narrowing of performance leadership is a signal that the rally in so-called growth stocks is fading. That was the case in the third quarter of CY 2023.

Regulatory risk is another issue. As the largest US tech stocks become ever more dominant, the risk of additional government regulation increases. 

Diversification is a further consideration. Investors who use index funds for exposure to the ASX 200 might do so to achieve ‘instant diversification’ through a basket of securities. But almost half of that index is held in 10 stocks, by market capitalisation. 

Clearly, investors need to take extra care using index funds – or active funds that ‘hug’ indices with their stock weightings – amid greater index concentration. Investors could benefit from  seeking active funds that are unconstrained by index composition and can identify opportunities outside of the narrow group of companies that dominate key indices. 

We believe that active managers with flexible mandates have greater scope over the long term to capture upside and limit downside, compared to passive index funds that must own everything in an index and allocate more capital to a small group of overvalued companies.
 
For more PM Capital insights, visit www.pmcapital.com.au/insights

Notes:

1 S&P Dow Jones Indices (2023), “Fact Sheet S&P500 Index”. At 29 September 2023. 
2 S&P Dow Jones Indices (2023), “Fact Sheet S&P/ASX 200 Index”. At 29 September 2023.
3 Australian Financial Review, “Three Reasons the Dividend Bonanza is Over”, 1 September 2023. As measured by the S&P ASX 200 Index.
4 Source FactSet. At 30 June 2023.
 

This insight is issued by PM Capital Limited (ABN 69 083 644 731 AFSL No. 230222) as the investment manager for the PM Capital Global Opportunities Fund Limited (ACN 166 064 875, ‘PGF’) and as the responsible entity for the PM Capital Global Companies Fund (ARSN 092 434 618), the ‘Fund’.
It contains information only and does not constitute an offer, invitation, solicitation or recommendation with respect to the purchase or sale of any securities of PGF or of the Fund. The information herein seeks to provide an insight into how and why we make our investment decisions, and is subject to change without notice. This information does not constitute advice or a recommendation, and is subject to change without notice. It does not take into account the objectives, financial situation or needs of any investor which should be considered before investing. Investors should consider ASX announcements, the Target Market Determinations and the current Product Disclosure Statement (which are available from us), and obtain their own financial advice, prior to making an investment. The PDS explains how the Funds' Net Asset Value are calculated. Past performance is not a reliable guide to future performance and the capital and income of any investment may go down as well as up.