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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
The writer is the editor of the FT
Current sale in the technology sector fueled by the progress of Chinese artificial intelligence startup DeepSeek is a reminder of the risks of a concentrated stock market. The top 10 stocks make up nearly two-fifths of the S&P 500. Such concentration is unprecedented in modern times. Equally weighted index products, which invest the same amount of money in each stock in the benchmark, are increasingly being touted as a way to avoid the risks of an increasingly concentrated portfolio. Should investors heed these calls?
More concentrated stock markets create less diversified passive portfolios. But that doesn’t have to be a problem for returns, or even risk-adjusted returns. Having a third of your portfolio in a handful of stocks generating high double-digit returns has been incredible for passive investors in recent years, though less so for those active managers who have undervalued Big Tech.
And there are good reasons why the biggest companies are so highly valued. Today’s corporate superstars are conquering global economies of scale. They produce and control valuable intellectual property and have demonstrated the ability to commercialize it. Their earnings grew quickly and steadily. Market prices tell us that investors believe that this trend can be sustained.
But the most valuable companies today are rarely the most valuable 10 years from now. Research Last year, Bridgewater Associates examined the performance of America’s most valued companies since 1900. By assembling a new cohort at the start of each decade and tracking their relative performances, the authors found that a market-weighted basket of the 10 largest stocks underperformed the market by an average of 22 percent over the following decade. Move the clock forward three decades and this underperformance has increased to 53 percent.
Such a dynamic is healthy. Tech superstars of the past such as Eastman Kodak, Xerox and Lucent have been supplanted by today’s Apple, Amazon and Alphabet. A certain combination of vigorous competition in part of the market and effective anti-monopoly machinery is essential for economic growth.
It is possible that today’s megacaps will be more successful than their predecessors in reinventing and disrupting themselves to fend off challengers or in stifling competition and taking over. But to believe so is to believe that this time it will be different. And for long-term investors considering equally weighted index products, this is a big call. A return to a less concentrated market requires weak results from the largest companies. This is what would likely drive the outperformance of the index’s equally weighted peers.
No one can know whether today’s megacap tech titans will maintain or perhaps even increase their market presence. A year ago, the elastic band felt stretched. Since then, the so-called Magnificent Seven have averaged returns of more than 60 percent in 2024. There is certainly no reliable quantitative model that will predict the future. And so, like much of investing, it all comes down to judgment.
Goldman Sachs announced its call in October. In his view, today’s index concentration will decrease, and the impact this has on long-term return estimates is profound. The bank’s forecasting team, led by David Kostin, estimates that the S&P 500 will return just 3 percent annually over the next 10 years. Without a change in index concentration, their call would be a return of 7 percent per year. As such, their basic expectation is that stocks will underperform US Treasuries – a historical rarity.
One of the appeals of passive market cap-weighted investing is that it offers a free ride on markets that have become efficient thanks to the analytical effort of active investors. Passive investors do not need to take a look at the prospects of any individual company. By contrast, investing in an equal-weighted index fund implicitly rejects the idea that the stock market is efficient.
Equal weight index products are a way to gain exposure to US stocks without betting that this time will be different. They offer investors diversification, but risk missing out if the Magnificent Seven continue their upward march. As the late Charlie Munger once observed, “diversification is for investors who know nothing.” His point was not that diversification is stupid, but that it dilutes any insights that professional investors may have. Theory dictates that Munger’s no-nonsense investor would be best suited to invest in market cap-weighted indexes. For those looking to take advantage of the view that today’s extreme concentration will revert to the average, equally weighted index products may prove more attractive.
