How Diversified Are US Equity Investors?

• Diversification is one of the bedrocks of investing. As U.S. equities outperformed global equities in recent years, the appeal of seeking opportunities outside the U.S. may have lost its shine for U.S. investors.
• The U.S. equity market has become increasingly concentrated. A smaller proportion of stocks outperformed the MSCI USA Index YTD compared with previous years. The top 5 stocks by weight accounted for a large proportion of risk and return.
• The greater sway of a small number of companies in the market comes with risks: Declines in these top stocks could outweigh more robust performance from the broader market.

Diversification is one of the world’s oldest principles. It is mentioned in the Old Testament,¹ by Shakespeare in The Merchant of Venice² and is one of the bedrocks of investing. As U.S. equities outperformed global equities in 2018, 2019 and 2020, however, the appeal of diversification through investing outside the U.S. lost its shine for U.S. investors. Additionally, the universe of U.S. large- and mid-cap stocks, represented by the MSCI USA Index, comprises over 600 securities. U.S. investors might not be blamed for assuming there are ample opportunities for diversification and potential risk reduction in the domestic market. But is this assumption correct?

The exhibit below shows two measures of concentration for U.S. and global developed-market (DM) equities: the weight of the top-10 constituents and the number of effective constituents in the MSCI USA and MSCI World ex. USA Indexes.³ By both measures, concentration in the U.S. market was the highest it has been for almost two decades, as of Oct. 30, 2020. The top-10 assets accounted for 26% of the weight of the MSCI USA Index. By contrast, measures of concentration in global DMs outside the U.S. have been stable, and lower, in recent years: The top-10 assets accounted for 11% of the weight in the index.

US Equity Market Showed Higher Levels of Concentration vs. the Rest of the World

The Average US Stock Underperformed the US Stock Market

The U.S. markets, as a whole, have held up well this year, defying the economic uncertainty due to the COVID-19 pandemic. That performance, however, mainly came from just a few assets. While the MSCI USA Index was up 12% YTD through Nov. 6, the average stock returned just over 3%.⁴ The exhibit below shows that only 34% of constituents outperformed the index year to date, which is low by historical standards. The corresponding figure for the MSCI World ex. USA Index was 44%. This could have implications specifically for active managers, who try to pick stocks they believe will outperform the index.

A Small Percentage of Stocks Drove US Equity Market Performance

Further, a handful of large stocks have been the dominant force in U.S. equities. The exhibit below shows that the top-5 stocks, the so-called FAAMGs, Facebook Inc., Amazon.com Inc., Apple Inc., Microsoft Corporation and Alphabet Inc. (the parent company of Google LLC), accounted for both a significant share of risk in the MSCI USA Index and an overwhelming share of returns over the last one-, two- and three-year periods ended Nov. 6, 2020. In contrast the risk and return contributions of the top-5 stocks in the MSCI World ex. USA Index were much smaller.

Risk and Return Contributions of Top-5 Stocks to MSCI USA and MSCI World ex. USA Index

Why Concentration Matters

Some investors may view the large tech names as a safe haven, delivering steady profits and revenue from online businesses, despite the uncertainty of the coronavirus pandemic. But the greater sway of a small number of companies in the market comes with risks: declines in these top stocks could outweigh more robust performance from the broader market.

The exhibit below shows that since the beginning of 2018, the MSCI USA Index posted an average daily return of 0.06% and posted declines on 44% of trading days. On the days when all five FAAMG companies’ share prices posted losses, the broader market had an average daily return of -1.18% and declined 96% of the time. While this analysis does not imply causation, it illustrates how the large companies can have a significant impact on the market return due to their high weight.

Stress Test Showed that When FAAMGs Fell The Market Fell Too

Data from Jan. 1, 2018 to Nov. 6, 2020.

A correlated stress test offers another way to analyze this effect. Given the current weight of Amazon, and its correlations with other assets, a simulation where Amazon drops by 10% implies a drop of 4.4% in the MSCI USA Index as a whole, according to our model. In that same analysis, we observed that if Microsoft drops by 10%, the MSCI USA Index declines by 6.1%, and last, but certainly not least, a scenario where an equally weighted hypothetical portfolio of the top-5 loses 10% implies a loss of 7.8% in the broader market.

Stressing the Big 5: Implications for the MSCI USA Index 

Hypothetical predictive stress test run using the MSCI Global Equity Factor Model for Long-Term Investors (GEMLT).

Concentration Hurt Diversification

Investors who are exposed to a universe of over 600 securities,⁵ through an index fund or an active manager, might assume they have ample opportunities for diversification. However, a portfolio of many names might be concentrated in terms of stock weightings and risks. We contrast the U.S. and the rest of the global-equity market on several measures of concentration and showed that investors in U.S. equities became more exposed to concentration risks in recent years. Seeking investments beyond the U.S. markets may provide greater opportunity for the potential risk-mitigating benefits of diversification.

¹“Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.” Ecclesiastes 11:2.

²“My ventures are not in one bottom trusted 
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore my merchandise makes me not sad.”
(William Shakespeare, The Merchant of Venice, act 1, scene 1.)

³The effective number of stocks is a measure of index concentration and ranges between 1 (for a single stock) and the number of stocks in the Index (for an equal-weighted index). It is calculated as the inverse of the Herfindahl-Hirschman Index (HHI).

⁴As of Nov. 6, the MSCI USA Equal Weighted Index had a return of 3.32% YTD.

⁵The number of securities in the MSCI USA Index.

Further Reading

Tapping into Global and Regional Revenues

Equity-Market Dislocation and Index-Based Investing

Does the Market Contain Too Much Facebook?