Redefining diversification in a concentrated equity market

Markets have had no shortage of headlines this year. War in Iran has reignited fears over energy security and regional stability. Brent crude surged at one point to $120. Qatari LNG exports halted. And nearly a third of global fertiliser trade was disrupted.

Meanwhile, AI is disrupting industries many thought were established, with the so-called SaaSpocalypse, AI tools eating into the software subscription model, a case in point. Layered onto markets already strained by concentration and stretched valuations, this has tested investor resilience to its limits.

For years, the debate around active versus passive investing has raged on. Over the past decade, passive strategies have gained popularity. Their simplicity, low costs, and strong performance have been the draw, as markets climbed to record highs.

For some, this performance has strengthened the case against active investing. We believe it is also a double-edged sword. Markets, like tides, are constantly shifting. Active strategies navigate these shifts with intent. Passive portfolios are bound to the current, leaving them vulnerable to choppier waters.

As a result, we believe the next decade could be challenging for those invested solely in passive and/or traditional strategies, unless they adjust their portfolios.

So, what’s clouding the once-clear waters of passive investing?

Why rising concentration and soaring valuations spell trouble

First, markets are more concentrated than ever. While markets have performed well over the past decade, most of the gains have come from a handful of stocks. As a result, indices and subsequently passive strategies, are now heavily reliant on a small number of mega-cap technology stocks.

For example, the US now accounts for roughly 70% of the MSCI World Index, whilst the top 10 stocks, largely American companies make up 27% of the index.

Should sentiment towards these mega-cap stocks reverse, as we have seen play out in past shocks, passive portfolios could face significant headwinds.

Second, valuations, particularly in the US, are circling historic highs. Near-record profit margins and continued expectations for robust earnings growth are the drivers. That leaves markets vulnerable to even slight earnings disappointments.

Typically, this setup (high market concentration and valuations), has historically not boded well for the future returns of passive equity strategies. 

And there’s another issue. When the market turns, history tells us that the most expensive areas fall the fastest and furthest.

Even without the current turmoil in markets, we think that the sections of the market that have delivered the best returns over the past 10 years are unlikely to repeat that stellar performance. Instead, we see much more significant downside risk. So, what can passive investors do to balance their portfolios?

Blending active and passive

One approach is to blend passive and active strategies. Unlike their counterparts, active strategies can navigate challenging environments with intent, potentially lending passive portfolios an extra degree of resilience.

Passive strategies are inherently vulnerable to turns in sentiment, when they are obliged to sell in lockstep. Active strategies are not forced to, they can choose to buy on conviction when stock prices fall, rather than selling on weakness as market-cap-weighted passive strategies typically do in our view.

This is not a zero-sum game. Passive strategies still have advantages when it comes to cost and convenience and work well for achieving core exposure.

Moreover, the performance of passive and active strategies tends to run in cycles, with one approach outperforming the other for some time before the ascendancy reverses.

But a combination of active stock picking and passive core holdings can provide a crucial balance that helps investors to steer their way through challenging and polarised market environments. But that’s just one layer.

Is the active portion truly diversified?

Beyond passive indices, investors should also be thinking about funds and strategies that stand out from the herd and complement their existing holdings/exposure. That way, they can hope to achieve diversification through investment style as well as by asset class.

Funds with a distinctive investment approach that deliberately looks different from the index are less likely to be correlated with generic passive approaches, and investors should be careful to ensure that their managers are taking a genuinely active approach rather than tightly hugging indices with just a nominal active share.

The same goes for regional exposures and underlying holdings. While gains have been concentrated in a handful of stocks, leaving limited opportunities for broader outperformance, this also creates an opportunity for active investors who are willing to take the road less travelled.

In our view, by adding an active manager who zigs when their passive portfolio zags, investors can potentially reduce the volatility within their overall portfolio.

In a world of highly concentrated markets, still-high inflation and heightened correlations, diversification is harder to come by. But achieving appropriate diversification is by no means impossible.

By blending active and passive strategies and seeking out opportunities with low correlations to the broad markets and their existing holdings, we believe investors can create portfolios that are more diversified and balanced, leaving them better positioned to navigate the choppy waters more smoothly.

Legal disclaimer: For financial advisers and wholesale clients only. Past performance is not a reliable indicator of future results. This is not financial advice and does not constitute a recommendation to buy, sell or hold any interests, shares or other securities, or to adopt any investment strategy. This represents Orbis’ view at a point in time, and we