Scientific Beta

The recent increase of concentration of the US 500 Cap-Weighted benchmark, largely driven by the "Magnificent 7” stocks, has prompted some investors to voice doubts over the benefits of holding well-diversified portfolios. Our objective with this paper is to provide an analysis of the concentration of the US 500 Cap-Weighted index over the last 50 years to characterise the current situation and analyse the impact of the Magnificent 7 stocks. We show that the current level of concentration is driven by a substantial level of outperformance by the largest capitalisation stocks, one that is extreme relative to history but not unprecedented. While over the long-term the largest caps underperformed the US 500 Cap-Weighted index by -0.6%, we observe that over the short-term their relative performance has been volatile and that periods of large outperformance did not last forever and were followed by periods of underperformance similarly large in magnitude. We also show that the largest capitalisation companies during these periods of extreme outperformance then systematically underperformed the cap-weighted benchmark in the subsequent years, whether looking at one- to 10-year horizons.

Finally, we show that the underperformance of well-diversified portfolios in periods of increasing concentration is not a surprise, since it is a direct consequence of large caps outperformance. However, over the long-term, well-diversified portfolios benefit from higher risk-adjusted performance than concentrated portfolios, thanks to their capacity to diversify away idiosyncratic risks which are not rewarded. Hence, Scientific Beta’s conviction is that diversification still matters for investors and will continue to be a crucial pillar of portfolio construction.