Why Diversification Is at Risk
With the correlation between stocks and bonds near generational highs, equity risk likely has quietly become more prominent in your portfolio. To further complicate matters, the concentration of major equity benchmarks has increased dramatically in recent years. This may cause equity risk itself to rise, tied to a handful of mega-cap tech names. You may want to reconsider whether your portfolio is sufficiently diversified. Let’s take a closer look.
The correlation between stocks and bonds has spiked recently to levels not seen since the 1990s. This relationship is highly dependent on the time varying nature of inflation as both stocks and bonds respond similarly to inflation uncertainty and anticipated Fed reactions. With inflation at elevated levels, so too is the level of correlation. This means bonds probably won’t diversify equity risk as they once did. As a result, equity risk likely contributes more to your portfolio’s total risk than it did before.
But equity risk itself is changing. In the COVID and post-COVID era, the concentration of equity benchmarks has increased dramatically. In December of 2019, the top 10 names in the S&P 500 represented 23% of the index’s market cap. Today, that has grown to more than 30%, with most of these names representing higher-volatility, growth-oriented, tech and communication services stocks. In fact, the S&P 500 Index of today has as much growth exposure as a 50/50 blend of the S&P 500 and the Russell 1000 Growth Index did in December of 2019. Equity benchmarks worldwide are increasingly skewing toward very concentrated growth.
One example is the NASDAQ 100, where just seven names make up 55% of the market cap of the index. To combat this high level of concentration and risk from a small number of names, the NASDAQ 100 underwent a special rebalance last week to partially de-emphasize the largest tech mega-caps in favor of smaller companies such as consumer discretionary firms Starbucks and Mondalez International. Between announcement date on July 14th and rebalance date, big tech names were down about 4%, highlighting the volatility created by attempts to fight concentration.
Equity markets may get choppier and you may not be as well diversified as you think. We think rising correlations and increasing concentration pose a serious threat to your portfolio. We favor lower volatility equity strategies for this type of uncertain risk climate.
Preparing for Potentially More Volatility
Equity markets may get choppier and you may not be as well diversified as you think. We think rising correlations and increasing concentration pose a serious threat to your portfolio. We favor lower volatility equity strategies for this type of uncertain risk climate.
MarketScape
Michael Hunstad, Ph.D.
Deputy Chief Investment Officer & Chief Investment Officer of Global Equities
Michael Hunstad is deputy chief investment officer and chief investment officer of global equities for Northern Trust Asset Management. Michael is a member of the Asset Management Executive Group and has oversight of all equity portfolio management, research and trading activities including quantitative, index and tax-advantaged strategies. Additionally, he assists with the development of investment vision, strategy portfolio construction and risk management framework for the firm’s broad investment platform.
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