The Passive Paradox

The Magnificent 7 combined have a market capitalisation of $17.6tn, accounting for over a third of the S&P 500's value as at end Dec 2024*. Five years prior in 2019, they accounted for 19.2% and in 2015 this allocation was 12.3%.[1] This might not be an issue for many investors in passive funds when markets are trending upwards, indeed when such a small number of businesses account for over a third of equity market performance, market weight exposure to these companies may seem like a good way to benefit from the growth of these businesses. It should also be noted that the true exposure to information technology companies is far more meaningful than at first glance. With Amazon and Netflix classified as consumer discretionary businesses, Google and Meta as communications services and Tesla as automobiles it is clear that the weighting towards technology goes beyond the standard sector classifications.

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At the time of writing, the MSCI All Country World Index (ACWI), which tracks large and midsize companies around the world, has 65% exposure to US companies.[2] These companies make up such a large proportion of the world index because of their success in recent years and there is no doubt that passive investors have benefited from this as many global tracker funds will be tracking against this index. However, it is crucial to understand the proportion of risk and volatility that is now embedded in holding these businesses, representing a seismic shift in the global stock market makeup and presenting investors with the so-called 'passive paradox'.

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Trump: "just getting started"

Since the start of the year, markets have witnessed a meaningful step change. US tech stocks have fallen sharply amid tariff uncertainty, questions over the strength of the US economy and concerns over AI competition from China. The Magnificent 7 fell 8.7% in February, bringing its loss since the turn of the year to 6.5%. Meanwhile, Nvidia stock fell 8.5% on the day of its earnings due to concerns over gross profit margins and US tariffs, despite the chipmaker's results broadly meeting analyst estimates.[3] In addition to this, US equities offer high valuations unlike other parts of the market which has prompted investors to exit expensive assets and called into question the assumption that recent winners will continue over the next decade. Recognising the risks of overconcentration and high valuations, we made the decision to include the S&P 500 Equal Weight Index within portfolios – one that has certainly helped in the current environment. While the Magnificent 7 has officially entered bear market territory (-14% at the time of writing), the Equal Weight Index has remained resilient on a relative basis. With Trump “just getting started”, investors are being forced to grapple with increased uncertainty and frequent bouts of volatility.

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Reassessing diversification

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The passive investment world is increasing in scope and complexity which paradoxically requires greater need for active involvement. At LGT we retain an actively managed approach to both the active and passive model portfolios that we run via a rigorous top-down asset allocation process. Decisions around asset allocation, tactical weightings to regions, use of market cap or equal-weighted indices are increasingly necessary to ensure appropriate diversification and to manage volatility. While the passive vs. active debate continues to rage on and divide opinion, perhaps the real solution is more nuanced than the evangelists would have us believe - suggesting that the answer lies in the interplay between both approaches.

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Sources: 

[1] Morningstar
[2] https://www.msci.com/documents/10199/8d97d244-4685-4200-a24c-3e2942e3adeb
[3] Factset