Technology overconcentration versus thematic diversification

Nasdaq implemented a special rebalance of the Nasdaq 100 index in July 2023. This has only happened twice before in its history in 1998 and 2003. This rebalance was required to address concerns following the rally of mega-cap technology companies over the year, which further increased their dominant weight concentration in the index. To mitigate this, Nasdaq reduced the aggregated weight of Microsoft*, Apple*, Nvidia*, Amazon* and Tesla* from 43.8% to 38.5%.

While no special rebalance has occurred in the S&P 500, there are similar concerns regarding the overconcentration of the ‘Magnificent Seven’ (Apple, Microsoft, Amazon, Tesla, Meta*, Nvidia and Google*). These seven companies combined account for over 25% of the S&P 500 index.

Alongside their growth credentials, the Magnificent Seven are viewed by investors as economic bellwether behemoths. The question now is if their outperformance relative to the rest of the US equity market will continue or not. If they do continue to outperform, then overconcentration concerns are likely to  heighten.

The rally is spreading. Can it last?

In recent months these mega-cap technology companies have continued to perform well; however, there are signs that the US equity rally has broadened.

Indeed, the S&P equally weighted index has performed more in line with the S&P 500 index during this period.

If the US economy continues to perform well, it may potentially remain the case that the Magnificent Seven perform in line with the market rather than outperforming as they did during the first half of 2023.

An alternative view could be that this mega-cap technology outperformance rally has run its course or that the recession risk materialises, leading to an equity market downturn.

Only last year equities underperformed, with the technology sector leading the downturn. If a recession unfolds, and the technology sector leads an equity market decline, then now could potentially be the time for investors to consider diversifying** away from the increasingly concentrated Nasdaq 100 and S&P 500 indices.

Thematic diversification

A systematic methodology e.g. modified equal-weight allocations and quarterly or semi-annual rebalances could avoid similar overconcentration issues in the event of large relative outperformances from individual names. Another alternative approach could be via a well-diversified investment in a global thematic universe.

A potential benefit of a diversified thematic approach could be maintaining exposure to the themes that have contributed to growth in the mega-cap technology companies this year, most notably AI. However, this would be alongside other dynamic and innovative long-term growth themes such as clean energy, healthcare, ecommerce and robotics. Investors could also gain exposure to an array of unique mid-cap and small-cap firms that do not overlap with existing market cap holdings.

In the event of a downturn, it’s possible that technology companies may fall faster than they did in 2022. In this scenario, a diversified global thematic approach could help to limit overconcentration risks, while also offering potential to benefit from long-term growth themes.

* For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

** It should be noted that diversification is no guarantee against a loss in a declining market.