Frequently hailed for their low costs and broad market exposure, tracker funds are a popular choice for many investors seeking passive investment strategies. However, beneath the surface, these funds may not offer the level of diversification that many assume. Writing for IFA Magazine, Nersen Pillay is Senior Investment Director at W1M, takes us through why he believes that advisers have an obligation to guide clients through the nuances of tracker fund diversification, especially as concentrated positions in certain sectors or companies can introduce hidden risks.
The Magnificent 7 and the Risk of Concentration Bias
Tracker funds are designed to replicate the performance of a specific market index, holding the same securities in the same proportions. At first glance, this appears to offer broad market exposure. However, the way most indices are constructed can significantly skew their diversification.
For example, many commonly used indices, such as the S&P 500, are weighted by market capitalisation. This means that larger companies, which represent a more significant portion of the index’s market value, have a disproportionately large influence on its performance. Clients invested in these funds may therefore find their portfolios heavily exposed to just a few high-market-cap stocks, particularly those in rapidly growing sectors like technology.
In fact, the S&P 500’s concentration in technology stocks has reached historic levels. The so-called ‘Magnificent 7’ – Apple, Microsoft, Amazon, Nvidia, Alphabet, Meta and Tesla – now make up approximately one third of the total market cap of the index. This significant concentration means that the performance of these seven companies has an outsized impact on the performance of associated tracker funds. This is not simply a theoretical concern, with seemingly not a day going by without a new warning of an AI bubble.
It’s not just US-centric indices that exhibit this problem, however. Global tracker funds, such as those that track the MSCI World Index, can also show a heavy skew towards the very same US technology stocks, reducing the overall geographic and sectoral diversification that many investors expect from a global fund.
Mitigating the Risks of Over-Concentration
Given these risks, it’s crucial for IFAs to ensure that clients aren’t simply assuming that a broad market tracker fund automatically equals diversified exposure across regions, sectors, and individual stocks. Instead, they should consider strategies to achieve genuine diversification and reduce the potential impact of concentrated sectoral exposure.
One way to address concentration risk is to take an active, stock picking approach, aiming to hold a portfolio of the best stocks in each global sector regardless of where they are listed. Modern Portfolio Theory suggests investors do not have to hold hundreds or thousands of stocks to be well diversified; in fact holding around 50 stocks can give very significant diversification in a global equity fund.
Diversification shouldn’t just stop at equity markets. It is also important to diversify across other asset classes. Incorporating bonds, real estate, commodities and alternative assets into a portfolio can help mitigate the risk posed by heavy concentrations in equities. Asset classes often respond differently to economic events; a well-rounded portfolio can provide additional resilience during market volatility.
The Picks and Shovels of Active Diversification
Actively managed funds offer the flexibility to adjust holdings based on market conditions, individual stock performance, and sector outlook. Skilled managers can provide a more targeted approach to diversification, avoiding the potential pitfalls of a potentially overexposed passive strategy. This can be an effective way to manage sectoral and stock-specific risks.
Active managers can build a portfolio of companies which, while containing fewer stocks than tracker funds, are highly diversified by sector and region. They also have the expertise to selectively pick stocks based on individual business fundamentals and growth prospects, not simply current broad market trends.
This could entail a ‘picks and shovels’ approach, investing in companies which supply a booming subsector, such as AI related technology stocks, while not being so reliant on a boom in a single stock or sector. A good example of this is the Japanese company Hitachi, which is doing very well supplying the cooling systems needed by the data centres powering the AI boom but is not dependent on that sector given its exposures to everything from the rail sector to the nuclear power industry. Another stock which benefits massively from the AI boom is Taiwan Semiconductor (TSMC) which is the world’s leading chip maker and whether Nvidia or AMD or other companies come up with the best AI chip design, TSMC is going to benefit from the increasing global demand for them on top of its existing non-AI related orders. Tracker funds simply can’t do this, and while ostensibly efficient and cost-effective, they may not always offer the level of diversification many investors expect.
As the market becomes more concentrated in a handful of large companies, particularly in the technology sector, IFAs might want to take a closer look at the risks associated with tracker fund exposure. By utilising broader asset class diversification and active management, advisers could help clients achieve the diversification needed in a volatile world.
