AI Insights

The Elephant in the Index—Addressing the Allure and Dangers of Over-Concentration

by Plotinus Plotinus No Comments

As the S&P 500 finishes its best first quarter performance since 2019, the concentration of the performance of the whole index in just a few stocks has been much noted. In particular its top performing stock, NVDIA with its +82% YTD, has contributed in excess of 5% to the index YTD.

This highlights a broader reality, that the market cap weighted index increasingly resembles a pareto cumulative distribution-like character, as shown by the chart below.

One can see that the market capitalization of the top 50 companies in the index account for 58% of the entire market capitalization of the index. This, like many other winner-takes-all phenomena, exhibits growing concentration. As recently as 2021 for example, the top 50 made up 54%. So, what is the effect of this growing concentration? Is it a potential risk or an opportunity?

To explore this let us look at the total return versions of the S&P 500 Top 50 index vs the S&P 500. Over a 10-year period, the Top 50 bettered its broader counterpart by 23% making a cumulative return of 298% vs 241% (see chart).

Interestingly from a risk/return perspective the Top 50 index is only mildly more volatile and clearly presents a better risk/return profile. In these ten years, it has an annualized return of 14.60% with a volatility of 15.59% compared with the S&P 500 TR 12.96% return with a volatility of 15.16%.

The Weakness of Sameness

This rosy picture of outperformance is what we see if we look at annual performance over the same period. The mega-cap selection does better in 7 out of 10 and it is also outperforming so far in 2024.

What these charts do not illustrate, however, is that there is further concentration in the concentration. Were we to zoom in further on the top 20 and then the top 10, one would observe a similar pattern. The drivers of the whole index remain the whales of the index. Hence focusing on them to the exclusion of the other constituents, simply dilutes the diversification that the broader index gives. This in turn leads to the conventional observation that diversification reduces volatility but at the expense of returns.

It is noteworthy that 2022 resulted in a significantly better (though negative) relative performance by the S&P 500. This indicates the weakness of over concentration. The increasing sameness of the upper end of the mega-cap companies necessarily means that they are exposed to similar dangers. In the event that conditions are against them, like the impact of inflation/interest rates, for example, the exhibit the same vulnerabilities.

Breaking Beyond the Conventional

Plotinus’ thinking on deploying AI to enhance investment decisions is that an AI approach must be able to offer insights that we do not observe from conventional approaches. Thus, an AI approach that is designed to view investment decisions differently should therefore be able to deliver solutions beyond what is available through standard methods.

This has led us to develop AI Trade Decision-Making that can actively manage a US equity index investment so that it can act as a hedge to a core US equity portfolio exposure. Hedging but without departing from the asset class. What this means in practice is that we have developed an approach that manages to defy the conventional risk/return compromise. Diversification is not just confined to trading different instruments. It is also possible to generate diverse returns by trading the same instruments, but in different ways. This is where AI, if used correctly, can offer alternative solutions that can help de-risk the increasing concentration present in mega-cap US equities.

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How European Pensions Could Manage Added Risk in Portfolio Exposures in Pursuit of Higher Returns

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In our previous commentary. we explored the detrimental impact of the profound change in the underlying population demographics on European pensions. As we observed, the financial engineering error European pension funds made was that they did not properly account for the shrinking population of pension contributors and the growing population of longer living pension recipients. This has left pension funds grappling with the prospect of potential future collapse unless some very serious financial re-engineering is engaged in to fix the problem. And we left off with a suggestion that a solution could come through the addition of AI-driven strategies within the asset allocation mix.

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Fixing The Leaning Towers of European Pensions

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What Tourists and European Pensioners Have in Common

It is perhaps only somewhere with the allure of Italy, a bastion of human culture and progress for millennia, that could make an engineering failure a tourist attraction. The Leaning Tower of Pisa has about half a million visitors each year, with millions of euros in investment over the years helping re-engineer a solution to stabilize it and prevent gravity from eventually bringing it crashing to the ground (and Pisa’s tourist revenues along with it). It perhaps could serve as a positive metaphor for the troubling situation for not just Italy’s but Europe’s pension funds and the millions of pensioners they serve.

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Yin and Yin, and Addressing the Market Dilemmas of Now in a Different Way

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October has not failed to live up to its reputation as a volatile month for the US stock market. For those seeking an explanation, the fall is being blamed on the rise of US 10-year treasury yields, which crossed 5% for the first time since July 2007. With risk-free investment around 5%, the shine is somewhat taken off risky US equity investments. In addition, the prospect of higher-for-longer borrowing costs does not bode well for US companies and by extension the stock market.

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Fooled by Cleverness: Is Your Portfolio Manager’s AI-Model Deceptively Skewed Towards the Most Recent Past?

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Sophisticated investors are (hopefully) already reaping the benefits of the AI wave, by picking the winners among the tech stocks that have had an AI-driven surge in value since the beginning of this year. It is rather more difficult, however, to take the next step searching for AI opportunities among money managers deploying the technology. There is a very good reason for this.

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The Case for An AI/AI (Artificial Intelligence / Alternative Investment) Portfolio Allocation

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Which alternative investments diversify your portfolio?

Investors agree that there are benefits in having diversification within a portfolio. Deciding how diversification should be achieved and to what extent to allow diversification allocations to have a dilutionary effect on a portfolio’s core investment allocation are among the most challenging choices investors have to make.

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