When it comes to pure performance there has been a flight to passive investment funds in recent years. Investment Association data shows that since the start of 2022 retail investors have invested £37 billion into tracker funds, and have withdrawn a staggering £89 billion from active funds. However this isn’t just down to bad stock selection.
The growth of big US technology stocks in particular have created a real problem for active managers who would naturally look to diversify their portfolios away from over-sized holdings in companies such as Apple, Microsoft, Alphabet, Amazon, Nvidia and Meta.
Recent research from AJ Bell has shown that including or excluding global and US equity sectors makes a significant difference when measuring the performance of active managers. As Fundsmith Equity manager Terry Smith has pointed out, just five big tech companies were responsible for 46% of the returns of the US’ S&P 500 index in the first six months of this year. Nvidia alone was responsible for 25% of the returns.
The problem doesn’t go away at a when looking at global equity. The S&P 500 now makes up around 70% of global stock market capitalisation, barely diluting the impact of these over-sized stocks. Without making an active decision to reduce exposure to the US tech giants, the ‘Magnificent Seven’ as they are often called, remain almost as dominant in a global equity fund as they do in a US fund.
Concentration risk is something active managers will seek to avoid, but managers who underweight these stocks or seek to find undervalued alternatives can struggle to match the returns of passively managed index funds or ETFs, leading to potential outflows as investors seek better-performing options. The problem is not confined to traditional active management. Vanguard, a name synonymous with low cost passive investing, have a UK bias in some of their flagship funds and performance has suffered slightly as a result of it’s reduced exposure to the US market.
That’s not to mention the other problems these stocks pose if you are a stock picker.
The rapid pace of innovation within the tech sector makes it challenging for active managers to stay ahead of market trends. Predicting which companies will be the next leaders or laggards requires significant research and foresight, and even then, the market can be unpredictable.
Furthermore, whilst these stocks have shown exceptional growth, their high price-to-earnings (P/E) ratios can make them seem overvalued based on traditional metrics. Managers must decide whether to buy in at these high valuations or risk under-performing if the stocks continue to rise. Nobody knows where the top of the market really is for these businesses, some of whom are charting new territory in Artificial Intelligence. The volatility of a stock such as Nvidia makes it very difficult to make a measured decision.
Whilst performance often catches the eye, it is also worth remembering that it is not the only criteria for investing. There are funds which target income, low volatility or investing in smaller companies because there are people who have a need for these solutions. For the time being, however, tech stocks pose a real headache for fund managers.