Managing concentration risk for DC members

We have observed strong recent performance across UK master trust Growth phase investment strategies as stock indices fared well in 2023. 

However, it is important to note that many widely followed indices are capitalisation-weighted (cap-weighted) and, therefore, the largest stocks can have a disproportionate effect on performance. 

This was certainly the case through 2023, as the “Magnificent Seven” mega-cap tech stocks (Apple, Microsoft, Google parent Alphabet, Amazon.com, Nvidia, Meta, and Tesla) drove the bulk of the gains.

• In 2023, the “Magnificent Seven” stocks returned about five times as much as the global (Developed Market + Emerging Market) large-cap index as a whole¹
• The market recorded the largest performance gap between cap-weighted index and equal-weighted index in the last 10 years¹

At the beginning of 2024, investors had anticipated continued equity market dominance from the Magnificent Seven, double-digit corporate earnings growth, aggressive interest-rate cuts from the Fed, and inflation that drops to 2% or lower and remains subdued. 

However, it appears that fewer stocks included in the Magnificent Seven are having a significant impact on the U.S. equity market; shares of two of the mega-cap tech companies declined during the first quarter of this year.

Why does this matter?

When an investor purchases a passive fund that tracks a cap-weighted global developed equity index today such as the MSCI World or All Countries World, they are exposing themselves to very high levels of company and sector concentration risk through the Magnificent Seven. Given the strong performance of these companies in recent years, they are trading at historically expensive valuations. This results in a fund that has high sensitivity to mean reversion as these valuations unwind. This faux diversification inadvertently exposes an investor to an increased potential for large losses. 

To help illustrate how this has played out in the past our Quantitative Investment Management Team looked to the Chinese Technology sector in recent years. We have plotted the price change for the largest seven Chinese tech stocks since 2018. A rapid acceleration in valuations through the COVID-19 pandemic in 2020 is visible, akin to a sector bubble. 

We have since observed a reversion of valuations back to prices that we would expect to see based on fundamental analysis. There are multiple external factors that have influenced this rise and fall, the specific details of which are not for this article, however, the principle remains. 

As an investor, had you bought a Chinese cap-weighted index tracker in late-2020 you will have experienced significant losses to date, with a contributing factor being the unwinding of the Chinese Technology sector valuations. 

Source: SEI, MSCI. Benchmark is MSCI Emerging Market. Past performance does not predict future returns

How to mitigate this: 

A simple solution to avoiding sector concentrations in passive, cap-weighted index trackers is to not purchase passive, cap-weighted index trackers. However, we recognise that for many investors they provide cost effective access to equities. For long-term DC investors though, we believe there is a better way to gain exposure to equity markets that has the potential to enhance returns throughout a member’s journey to retirement whilst helping to mitigate against some of the risks we have highlighted.  

Taking a step-back, our view is that there are four main methods of implementing an equity strategy: 

1. Traditional Passive
   • Replicate the returns of a specified index
2. Smart-Beta (think of this as Passive Factor)
   • Construct a portfolio based on alternative set of index rules, in this case tilting according to a published factor ‘recipe’ 
3. Active approach to Factor
   • Construct a portfolio based on proprietary factor definitions, actively managed, overseen and continually developed by a Quantitative Investment Management Team 
4. Traditional Active
   • Construct a portfolio based on fundamental analysis and constraints, actively managed by a specified team

When compared across a variety of metrics, an active approach to factor investing is attractive for a number of reasons: 

Focusing in on risk management, we believe there are multiple components to an active factor approach that result in more robust risk management to the other methodologies.

Firstly, targeting companies that score favourably through our proprietary Value, Quality and Momentum definitions rather than passively tracking an index helps us manage exposures the sector concentrations and extreme valuations seen in the market today.

Secondly, this fund is actively managed by the relevant Portfolio Manager who is based in the Quantitative Investment Management Team. In contrast to smart beta factor funds or exchange-traded funds (ETFs) – which remain static by design – we’re able to tilt and adjust our factor exposures based on our outlook.

In practice, within the SEI Factor Allocation Global Equity Fund, this risk management process has resulted in an aggregate underweight of over 6% vs the MSCI ACWI benchmark across the “Magnificent Seven” as of 29 February 2024². 

A young DC investor today has an extremely lengthy time horizon and an ability to withstand Equity market volatility. However, we believe the use of passive cap-weighted indices may be overexposing them to extreme valuations and introducing high levels of concentration risk. A thoughtful, considered investment implementation such as an active factor approach can go some way to help mitigate this. 

Get in touch if you’d like to find out more about our investment process and approach to glide path implementation: 

¹Source: SEI, FactSet, MSCI. Universe: All Country World Large-cap equities 2023.

² Source: SEI, as an actively managed strategy exposure to specific companies can be subject to change at any time. This aggregate underweight represents the combined difference of each individual “Magnificent Seven” company vs the benchmark. The “Magnificent Seven” are defined as Apple, Microsoft, Google parent Alphabet, Amazon.com, Nvidia, Meta, and Tesla. The benchmark for the SEI Factor Allocation Global Equity Fund is the MSCI ACWI Index.

Important Information:

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