Index concentration comes back to bite investors
Your portfolio may not be as diversified as you think.
Two seemingly contradictory statements can both be true:
• the US was one of the worst performing stock markets of 2022
• the best performing stocks in the world in 2022 were mostly US companies
On the first, after years of being top dog, the US market lost investors 19% last year. This put it in 17th position out of the 23 countries in the MSCI World index of developed market stocks.
But this was driven by a handful of tech behemoths which dragged the market down. A portfolio of the seven largest US companies from a year ago would have lost investors 40% in 2022 (Figure 1). A portfolio of the rest would have lost only 14%.
The US market has become increasingly concentrated in recent years, a risk we have been highlighting for some time. A small number of companies have been in the driving seat when it comes to the market’s performance. That risk came home to roost last year.
It is within those remaining companies that many of the best performing stocks globally could be found in 2022. Eight of the top ten performers were US companies. 16 of the top 25 were, as were 53 of the top 100. US companies made up about 41% of the companies in the MSCI World index at the start of the year so it has punched above its weight in delivering good performers.
Most of these very good performers are in the energy sector, including all of the eight in the top ten. With a 119% return, Occidental Petroleum is top of the pile, followed by Hess, Exxon Mobil, Marathon Petroleum and oilfield services company, Schlumberger. Further down the top 25 are steel producer, Steel Dynamics and three US healthcare companies.
The strong performance of energy companies should not be a surprise, given the rise in the oil price in response to the war in Ukraine. If we were to repeat this same analysis in a year’s time the top performers will almost certainly be different.
But what will continue to be the case is that high levels of concentration in the US stock market, and others, means only a handful of stocks will exert an outsized influence on the returns investors earn.
In previous years this was to US stock market investors’ benefit. Over the 2020-2021 period, US equity returns would have been around 20% lower without these seven companies (34% vs 54%). But last year it was to their cost.
It is very important for investors to understand the concentrated exposures they are taking on, often unwittingly, when allocating to broad market indices. This could be in terms of stock, sector, style, or region. Achieving balance and diversification is, sadly, not as simple as investing in a portfolio of global stocks.