Passive equity portfolios continue to gain popularity, but some investors might not know that a small group of outperforming stocks have driven most of the gains in recent years. Concentration risk could become a big burden if the favorable environment for these companies sours.
Since 2010, investors have flocked to exchange traded funds (ETFs) and index mutual funds, seeking market returns at a cheaper price than actively managed portfolios and without the underperformance risk. And active management results have generally disappointed investors over the last decade.
But passive strategies’ performance has been driven by a hidden threat: concentration risk. While the investment landscape has been conducive to delivering outsized returns for a select few stocks, what could happen if the favorable environment these companies enjoy sours? This question is becoming especially pertinent as worldwide inflows to equity funds have surged to $576 billion in the past five months through early April—exceeding combined inflows of $452 billion over the previous 12 years, according to Bank of America.
Why Concentration Hurts
Concentration risk increases when exposure to a single stock, sector or style becomes too large relative to the other parts of a portfolio or index. Sometimes it happens on purpose—when managers take a big, high-conviction position in the portfolio. But other times, it occurs when oversight fails, or the investment process lacks the proper mechanism to rebalance. In those instances, the favored positions swell relative to other portfolio holdings, becoming an increasingly dominant part of the whole. This is the case for many portfolios today, especially passively managed ones.
The US stock market has delivered strong returns in recent years. But as concentration has risen, that robust performance has mostly been fueled by narrow leadership among a handful of companies. Over the last several years, the five largest US stocks have become an increasingly sizable proportion of the overall market—doubling from 11% in 2017 to 22% in 2020 (Display).