Funds tracking indices such as FTSE All World or MSCI ACWI offer exposure to over 2000 constituents at the fraction of a cost thus solving the puzzling problem of home bias.
But markets never stand still or rise in parallel. Since then US equities raced ahead of all other regions, delivering a 10-year cumulative return of over 300 per cent, far above the 110 per cent average for the UK, Europe, Asia-Pacific and emerging markets as of December 2019.
The unintended consequence for global indices was staggering. The US started the previous decade with a weight of just under 40 per cent in the global equity index MSCI ACWI, but today it sits at a whopping 58 per cent and is five times larger than all 25 emerging markets combined.
Some investors may argue that many US stocks are global leaders that transcend borders, making their geographical location irrelevant. However, concentration risk is not just geographical.
Just as the US dominates the global index, technology stocks in turn have become dominant within US equities. At the peak of the dot-com bubble, the ‘big five’ US stocks in the global index made up nearly 19 per cent of the S&P 500.
Today’s top five - Microsoft, Apple, Amazon, Google (Alphabet), and Facebook (FAAMG) - add up to nearly a quarter of that same index. Indeed, market concentration has not been this high for the last 30 years.
Dissecting the performance of the S&P 500 reveals that, at the extreme end, in periods such as the first half of 2018, where five technology stocks could explain nearly 90 per cent of index returns.
The performance of the remaining 495 stocks was just a sideshow to what was happening at the headquarters across Silicon Valley and the outskirts of Seattle.
However, six months later the same ‘usual suspects’ were behind one third of the equity sell-off in the last quarter of that year.
This chart below demonstrates the dominance of these five stocks in both gains and losses for the index.
The irony is that while investors may feel that they are well diversified by investing in global indices, they actually are open to significant stock-specific concentration risks.
The latter in particular is sensitive to news-flow which is a relevant consideration if volatility continues or grows. This is quite different from the ‘well-diversified’ and ‘balanced’ exposure that many investors in index trackers often look for.
Having a large US and technology exposure may not cause widespread investor concern, but in fact may seem quite appealing. A recent Citigroup survey showed that over 40 per cent of investors want to be overweight US equities over the next 10 years.
And technology companies are still well-loved and have shown resilience during the pandemic as the world relies on their services to work, buy vital goods, and connect with loved ones.