Dealing with Concentration Risks

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One of the most common questions that we receive from clients these days is how they should think about the significant weight of the “Magnificent Seven” (Microsoft, NVIDIA, Apple, Amazon, Google, Meta, Tesla) in their equity portfolio. In case you aren’t aware: As of September 13, these Magnificent Seven (“Mag 7”) make up ~19% of the MSCI All-Country World and MSCI World Indices, and a stunning >42% (!) of the NASDAQ Index.

In our view, the issue doesn’t necessarily lay with the fundamentals of those companies. While the Mag 7 are certainly not cheap, they are still some of the largest, fastest-growing (and in some cases most profitable) companies in the market. On the qualitative side, there is an equal number of arguments to make for those companies, ranging from unparalleled supply chains (Apple) to massive industry tailwinds (NVIDIA) to what some call a monopoly (Alphabet). (Of course, none of these points should be construed as investment advice.)

Instead, it is the subsequent risks that this overweight brings to the ETFs and index funds invested in those companies, and thus, the overall portfolio of an investor. We are big proponents of ETFs and their ability to provide investors with low-cost, diversified access to a variety of markets - if anything, there’s a lot more to do wrong by not using ETFs. But when an ETF’s key benefit of diversification is in question, it’s when investors should think about whether they need to make changes.

With that in mind, we want to tackle three questions: First, why exactly this concentration risk might be bad for your portfolio. Second, who should be worried about it. And third, how to mitigate it.

The Risks of Over-Concentration

As mentioned before, we are not the ones to judge whether the overallocation in the Mag 7 is a good or a bad thing. 

Some people might refer to their performance over the last years - to which I of course have to add that historical performance is no indicator of future performance. Just because the Mag 7 (and technology stocks as a whole) have done well over the last decade does not mean that they will continue to do well in the future. There’s countless discussions among investors when (or if) will see a resurgence of value stocks over growth stocks. 

But as I mentioned, I don’t have a horse in that race. I’m focused on potential risk factors resulting from the overallocation to just seven stocks. 

As the first risk factor, the idiosyncratic exposure. If you buy an MSCI World ETF, you likely buy it for the significant diversification benefits offered by such stocks - according to MSCI, their MSCI World index offers exposure to over 1.400 companies (as of August 2024). So no matter if an industry, geography, or individual company does well or poorly for a while, you would think that the diversification, coupled with an ETF’s mechanisms causing companies to enter or leave the index, should protect you from events at the level of an individual company. 

But with the current overweight in the Mag 7, an investor in a MSCI World ETF does not quite have this benefit anymore. Despite their respective market-leading positions, Mag 7 companies are not immune against sudden drops in their stock price. Just two weeks ago, Nvidia dropped by 5% in a single day (after being down 11% at its low during the day); earlier this year, Meta saw an over 10% 1-day drop after disappointing earnings. Such moves are not unusual for a single stock - but you might’ve bought an ETF precisely to be not exposed to single-stock movements more akin to an actively managed equity fund.

Which brings us to our second risk factor: The impact on your portfolio’s overall risk profile. I have always seen myself more of a tech sector optimist rather than a pessimist. Yet it is without doubt that tech stocks, with their higher growth and (often) lower profitability than more ‘boring’ industries, have more risk and volatility than counterparts from other sectors. From its dotcom bubble peak, the NASDAQ saw a stunning 83% (!) drawdown lasting from March 2000 to February 2015, compared to a more modest maximum drawdown of ‘just’ 55% for the S&P 500 during the Financial Crisis.

Admittedly, the Mag 7 today don’t have a lot in common with the insanity of the dotcom bubble. They are (mostly) profitable, steadily growing companies with fortress balance sheets. But they are still tech stocks with higher volatility and risk - and at their current weight in common ETFs, also affect the risk factors of ETF investors who think they picked the less risky option with their investment.

Now we know the risks we are facing. But who should be worried?

Know Your Risk Profile

Frequent readers know that my #1 piece of advice is to know your Investment Objective: Don’t just set an arbitrary return goal, but tailor your portfolio to the actual required return and bearable risk, which should ideally also be based on specific, quantifiable goals - such as an income requirement or a desired nest egg for your retirement. (And for that part of your investing journey, I recommend the Aspirational Investor Framework.)

And because if you don’t know your required return, or the level of risk that you can bear, it’s hard for you to evaluate whether you should lose sleep over the Mag 7 weight - or if you can rest peacefully at night:

If you’re in your early twenties with a monthly ETF savings plan aimed at boosting your retirement, the Mag 7 weighting probably shouldn’t concern you at all. Here, you can rely on an ETF’s mechanism to automatically rebalance in and out of stocks according to their weight of the index. Perhaps Mag 7 will turn out to be overvalued, sending your ETF lower at some point in the near or far future - but since you’re adding to your position on a monthly basis anyway, perhaps even at that lower price, the Mag 7 overweight isn’t something that you should worry about.

If you just sold your tech start-up and are now looking to invest your proceeds for long-term income, you should be mindful of Mag 7. Most of the tech entrepreneurs that I know are overallocated significantly to tech, for example through a potential remaining stake in their business, venture capital fund and direct investments, or single tech stocks (often those part of the Mag 7). They’d deem the public equity ETF of their overall portfolio as a relatively safer bet, without taking into account that it further increases their tech sector allocation. There’s also second-order effects, such as the perceived correlation between NVIDIA and the current AI trend, to which you might be exposed through direct investments in VC stocks.

If you’re about to retire, potential risks to your public equity ETF should definitely be top of mind for you. But not necessarily (just) because of the overweight in Mag 7, but because of the significant drawdown risks embedded in equity as an asset class. As mentioned before, the current weightings might make indices including those stocks slightly more risky than they have historically been in a more ‘balanced’ form - which should motivate you to continuously reconsider your asset allocation, and its alignment with your risk and return parameters.

So if you find yourself negatively affected by the Mag 7 overweight - how can you mitigate them?

Ways to Mitigate Concentration Risk

Your first thought would be to address the issue directly: Thinking about ways to reduce the weighting of Mag 7 in your equity portfolio. 

One common suggestion that we’ve heard from clients is to switch from market cap-weighted indices to equal-weight indices, which as the name says, try to equally allocate the funds of an ETF to all stocks in the index. In the NASDAQ index, switching to equal-weighted would reduce our exposure in Mag 7 substantially from 40% to just 7%. 

Yet investors should be advised that even passive investments can be active bets: Changing your allocation to Mag 7 from 18-42% to 7% or even lower clearly falls into the territory of an active management-sized bet. You need to be able to bear the consequences of this choice, which (assuming it was the right choice) might take considerable time to play out. But perhaps you also don’t need to switch entirely: You could also shift some of the exposure to the market cap-weighted ETF, bringing you closer to a Mag 7 weighting that you find bearable. For example, switching just 20% of your MSCI ACWI exposure to an equal-weight ETF would reduce your Mag 7 exposure by 4%, i.e. 2% per Mag 7 stock, slightly more in line with a typical single-stock exposure limit in a diversified portfolio.

Alternatively, you could try to adjust the composition of your overall equity portfolio away from US-centric tech exposure. While the US has without a doubt been the driver of public equity returns in the last years, it is unsure whether that rally will continue forever. Investors can reallocate in other regions (i.e. Europe, Asia-Pacific, or Emerging Markets) and/or to other company sizes (i.e. small and mid cap) in order to reduce the overall weight of Mag 7 (and US and/or tech as a whole) in their portfolio. Investors especially concerned by the tech exposure could also adjust their sector weightings in a more granular fashion - however, there we would warn that sector ETFs typically tend to be more expensive, and are also often more akin to an active bet.

And lastly, investors should assess diversifying their equity portfolio into other asset classes. Many investors are rightfully biased towards equities given their historically high long-term return. But the same investors should also be reminded that this return comes at a cost, with equities historically being a comparably risky asset class as well, both on a volatility and a maximum drawdown basis.

If you are a young and very long-term-oriented investor like I mentioned before, this might not affect you so much. But if you are investing a larger portfolio and/or start thinking about more complex Investment Objectives such as ongoing income from your portfolio, diversification into other asset classes should be top of mind: Fixed income is offering investors attractive ongoing yields again, commodities have proven their worth in a portfolio in the recent periods of high inflation, and alternative assets might also boost returns or provide stable income. 

Looking beyond equities shouldn’t be an afterthought, but a priority: Rather than facing the challenge of how to rebalance within your equity portfolio, investing elsewhere might be a non-obvious, but after all, easier choice than you might’ve thought.

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