Hong Hon, Manager, Global Equities, Lonsec
The current global equities environment is increasingly defined by an uncomfortable paradox – the performance of broad benchmarks that appear diversified on the surface are being driven by an ever-narrowing set of stocks, sectors and countries. This dynamic is evident across both the MSCI World and MSCI Emerging Markets (‘EM’) indices, and poses a growing challenge for active managers, particularly those with valuation discipline.
The result is an environment where benchmark-relative risk is rising, portfolio beta may be unintentionally drifting, and the need for more deliberate risk management is becoming paramount.
The rise of benchmark concentration
In recent years, both the MSCI World and MSCI EM indices have experienced a notable increase in concentration.
In developed markets, the dominance of US mega cap stocks, particularly within the technology sector, has pushed benchmark weights to levels rarely seen outside periods of speculative bubbles. A handful of stocks, particularly within the ‘Magnificent Seven’ cohort, now account for a disproportionate share of the overall market capitalisation and returns, effectively skewing the opportunity set for active managers that are benchmarked to these indices.
Emerging markets have mirrored this trend, with concentration influenced not only by top-heavy country exposures – most notably Taiwan, China and South Korea – but also by a number of stocks within the technology sector, particularly within AI-related industries. As a result, diversification benefits traditionally associated with EM investing have diminished, and idiosyncratic risks tied to specific countries and sectors have become more pronounced.
This structural shift matters because traditional index construction approaches (i.e. market cap weighted) naturally amplify the influence of winners. As markets reward a narrow cohort of stocks, their index weights increase, further concentrating benchmark exposure and reinforcing a feedback loop.
Narrow earnings leadership and market performance
A key underpinning of this concentration has been the narrower breadth of earnings leadership. Earnings growth has increasingly been dominated by a select group of stocks and sectors – notably within technology, and by geographies – primarily the US in developed markets, and Taiwan and South Korea in EM.
This narrow leadership has translated directly into market returns, whereby a significant portion of benchmark performance has been driven by a small number of stocks, often those perceived as structural growth beneficiaries. In many cases, these stocks have delivered both strong earnings growth and expanding valuation multiples, compounding their impact on indices.
The implication, however, is that market breadth has weakened. Beneath headline index gains, a large proportion of stocks have lagged or even declined. This divergence creates a disconnect between index performance and the experience of active managers, who are often more diversified and less concentrated in the dominant names.
The valuation discipline challenge
For active managers, particularly those that are valuation-sensitive, the current environment presents a fundamental tension. Many of the stocks that are driving benchmark returns are trading at elevated multiples, reflecting high expectations for future growth. While some of these expectations may ultimately be justified, the starting valuation often leaves little margin for error.
Valuation-sensitive managers may, therefore, find themselves underweight or completely naked the stocks that are most contributing to benchmark returns. Instead, they may be overweight to the cheaper segments of the market – areas that appear attractively valued, but may lack near-term catalysts or are structurally challenged.
This may also lead to persistent relative underperformance, particularly during periods when valuation dispersion widens and growth stocks continue to outperform.
Importantly, while the decision to avoid more expensive market leaders is often intentional and grounded in long-term investment philosophy, its short-term impact on performance – and risk metrics, can be significant.
Rising active risk and unintended beta drift
One of the most notable consequences of this dynamic is the impact on the manager’s active risk. As portfolios deviate more meaningfully from concentrated benchmarks, tracking error naturally rises. While higher tracking error can be acceptable – and even desirable – for active managers when it reflects differentiated insights, it can also introduce unintended risks.
A specific concern is the potential for unintended decrease in portfolio beta. Portfolios that underweight the high-beta, high-momentum stocks that dominate indices may exhibit lower sensitivity to the overall market. Conversely, overweight positions in cheaper, more cyclical stocks may introduce exposures that behave very differently throughout the market cycle.
This shift in portfolio beta may not always be explicitly targeted, yet it can materially impact portfolio performance, as seen during the recent market rallies led by benchmark heavyweights. In such environments, active managers may lag not only because of stock selection, but also because their portfolios are structurally less exposed to the drivers of market returns.
The imperative for enhanced risk management
Given these challenges, the importance of robust risk management and monitoring cannot be overstated. Investors must go beyond traditional measures of tracking error to understand the underlying sources of risk within their portfolios.
This includes:
- Factor analysis: Assessing exposures to style factors, such as growth, value, momentum and quality, and understanding how these exposures compare to the benchmark.
- Concentration metrics: Monitoring both benchmark and portfolio concentration, particularly at the stock, sector and country levels.
- Beta and sensitivity analysis: Evaluating how the portfolio is likely to behave under different market scenarios, including continued narrow leadership versus a broadening of market returns.
- Scenario testing: Stress-testing portfolios against potential shifts in market leadership, such as a rotation from growth to value, or from developed to emerging markets.
Investors must also be prepared for periods of underperformance if they are to support active managers that are positioned for longer-term normalisation in market leadership and valuations.
Transient or structural?
The current environment raises an important question: is the concentration currently observed in global equities a transient phenomenon, or a structural feature?
While technological disruption, globalisation and capital flows may continue to favour large, dominant companies, history suggests that extreme concentration and narrow leadership are seldom permanent.
For active managers, the challenge is to remain disciplined without becoming dogmatic. Navigating the current environment requires balancing conviction with adaptability and maintaining a clear understanding of how portfolio positioning interacts with the evolving market dynamics.
Ultimately, as benchmarks become less representative of the broader opportunity set, the case for active management may strengthen – but so too does the need for robust risk management. In a market where fewer stocks are doing more of the heavy lifting, the margin for error has narrowed and the cost of deviation, both intentional and unintended, has materially increased.
Important Information: This article has been produced by Lonsec Research Pty Ltd ABN 11 151 658 561, AFSL No. 421445 (Lonsec). Generation Development Group Limited ABN 90 087 334 370 is the parent company of Lonsec Research.
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