wealth management
wealth management
Podcast
If you want to invest cost-effectively in the broad equity market, you use ETFs. It is not without reason that investors have been relying on the undisputed advantages of passive index tracking for many years. Indices with a US focus such as the MSCI World or the S&P 500 are particularly popular; after all, the high level of diversification across a large number of companies ensures an attractive risk/return profile, doesn't it?
In fact, this supposed golden rule is currently being shaken - and not for the first time. What many people are overlooking is the concentration of individual companies in the overall valuation of the indices. Many indices do not weight companies equally, but according to their market capitalization. This means that the larger the company, the higher its share of the index.
If we compare the current concentration of the US equity market with developments in the past, it is historically high. This reveals a constellation reminiscent of the high points of the dotcom bubble in 2000.
The sharp rise in the share prices of technology giants such as Apple, Microsoft and Amazon has significantly increased their stock market values and consequently their weighting in leading indices such as the MSCI USA and S&P 500. As the fundamentals have not risen to the same extent, the ratio between the share price and fundamental values (the "valuation") of the companies is very high - and therefore also in the leading indices such as the S&P 500.
Back then, too, it was technology-related companies that achieved exorbitant valuations due to the internet boom - until the crash followed.
The acronym "FAANGM" is representative of Facebook (Meta), Amazon, Apple, Netflix, Google (Alphabet) and Microsoft. The term was popularized in 2013 by Jim Cramer, the host of the CNBC show "Mad Money".1
To date, there have been various changes to the name, such as "Magnificent 7" or variations of the acronym, which sometimes included other companies such as NVIDIA or Tesla and sometimes left others out. In the following, however, we refer to the "FAANGM" variant.
The sharp rise in FAANGM share prices has significantly increased their market capitalization and consequently their weighting in leading indices such as the S&P 500, MSCI ACWI, MSCI World and MSCI USA. Their share in the latter is now around one third. As a result, many investors rely on the broad diversification of a corresponding ETF without realizing that just six companies dominate 33% of its portfolio.
As the FAANGM are currently very highly valued, this is pulling up the valuation of the entire standard indices. This means that the indices are once again dependent on a small number of previously successful market participants. This may be seen as a positive factor in the upswing phase, but we know from historical observation that this is highly unlikely to continue. So how should investors react to this?
To effectively counteract the concentration risk, equally weighted indices offer a lucrative alternative. The S&P 500 Equal Weighted Index, for example, is based on the same companies as its better-known counterpart, but weights them equally. Put simply, this means that while it benefits less from the rise of individual companies, it also avoids their overvaluation. A factor that makes it and corresponding investments a much safer addition to your own portfolio now that experts are discussing the development of a new bubble.
As history shows, a high concentration in the US equity market can occasionally build up over many years. Eventually, however, it disappears again and the few large companies lose relative value. In this phase, indices based on equal weighting perform significantly better than indices based on market capitalization weighting. The trend reversal often started independently of the economic cycle. One example: The dotcom bubble burst in March 2000, while the economy only dipped into recession a year later.
Although it is not possible to predict the future precisely, investors should pay appropriate attention to the current warning signals on the US stock market.
1JasonFernando: FAANG Stocks: Definition and Companies Involved, 24.09.2023, https://www.investopedia.com/terms/f/faang-stocks.asp
(as at: 19.04.2024)
wealth management
We are currently seeing a high concentration of large technology companies such as Apple and Google in leading share indices such as the S&P 500 and the MSCI USA on the US stock market. A constellation reminiscent of the dotcom bubble in 2000. So what can investors do to avoid the risk of overvaluation in their portfolio?
If you want to invest cost-effectively in the broad equity market, you use ETFs. It is not without reason that investors have been relying on the undisputed advantages of passive index tracking for many years. Indices with a US focus such as the MSCI World or the S&P 500 are particularly popular; after all, the high level of diversification across a large number of companies ensures an attractive risk/return profile, doesn't it?
In fact, this supposed golden rule is currently being shaken - and not for the first time. What many people are overlooking is the concentration of individual companies in the overall valuation of the indices. Many indices do not weight companies equally, but according to their market capitalization. This means that the larger the company, the higher its share of the index.
If we compare the current concentration of the US equity market with developments in the past, it is historically high. This reveals a constellation reminiscent of the high points of the dotcom bubble in 2000.
The sharp rise in the share prices of technology giants such as Apple, Microsoft and Amazon has significantly increased their stock market values and consequently their weighting in leading indices such as the MSCI USA and S&P 500. As the fundamentals have not risen to the same extent, the ratio between the share price and fundamental values (the "valuation") of the companies is very high - and therefore also in the leading indices such as the S&P 500.
Back then, too, it was technology-related companies that achieved exorbitant valuations due to the internet boom - until the crash followed.
The acronym "FAANGM" is representative of Facebook (Meta), Amazon, Apple, Netflix, Google (Alphabet) and Microsoft. The term was popularized in 2013 by Jim Cramer, the host of the CNBC show "Mad Money".1
To date, there have been various changes to the name, such as "Magnificent 7" or variations of the acronym, which sometimes included other companies such as NVIDIA or Tesla and sometimes left others out. In the following, however, we refer to the "FAANGM" variant.
The sharp rise in FAANGM share prices has significantly increased their market capitalization and consequently their weighting in leading indices such as the S&P 500, MSCI ACWI, MSCI World and MSCI USA. Their share in the latter is now around one third. As a result, many investors rely on the broad diversification of a corresponding ETF without realizing that just six companies dominate 33% of its portfolio.
As the FAANGM are currently very highly valued, this is pulling up the valuation of the entire standard indices. This means that the indices are once again dependent on a small number of previously successful market participants. This may be seen as a positive factor in the upswing phase, but we know from historical observation that this is highly unlikely to continue. So how should investors react to this?
To effectively counteract the concentration risk, equally weighted indices offer a lucrative alternative. The S&P 500 Equal Weighted Index, for example, is based on the same companies as its better-known counterpart, but weights them equally. Put simply, this means that while it benefits less from the rise of individual companies, it also avoids their overvaluation. A factor that makes it and corresponding investments a much safer addition to your own portfolio now that experts are discussing the development of a new bubble.
As history shows, a high concentration in the US equity market can occasionally build up over many years. Eventually, however, it disappears again and the few large companies lose relative value. In this phase, indices based on equal weighting perform significantly better than indices based on market capitalization weighting. The trend reversal often started independently of the economic cycle. One example: The dotcom bubble burst in March 2000, while the economy only dipped into recession a year later.
Although it is not possible to predict the future precisely, investors should pay appropriate attention to the current warning signals on the US stock market.
1JasonFernando: FAANG Stocks: Definition and Companies Involved, 24.09.2023, https://www.investopedia.com/terms/f/faang-stocks.asp
(as at: 19.04.2024)
About the author
Benjamin Moritz
Dr. Benjamin Moritz is responsible for Quantitative Investment Research at FINVIA.
After completing his degree in business mathematics at Koblenz University of Applied Sciences, he worked at Sal. Oppenheim in Cologne from 2008 to 2018. There he managed the cross-divisional investment processes for the bank's strategic asset allocation and annual investment outlook. He was also jointly responsible for tactical asset allocation for institutional and private clients and was the portfolio manager responsible for five public and special funds.
In addition to his work, he completed his doctorate at the LMU Munich under Prof. Stefan Mittnik from 2012 to 2018. He presented his research work in the field of computer-based text analysis for asset allocation and machine learning for stock selection worldwide and received two awards. In 2018, he continued his career at the newly founded HQ Asset Management. There he developed an investment platform and cross-divisional investment processes for asset allocation and stock selection, where he integrated his research results.
Since 2017, he has regularly supervised students from LMU Munich, UC Berkeley and TU Munich, for example, on master's theses and industry projects on current investment research topics.