Introduction

The concentration within the S&P 500 has reached unsustainable levels in the past year, with the prominent "Magnificent Seven" now representing a staggering 28% of the entire index, while the remaining 493 stocks make up the balance (Chart 1). Such pronounced concentration often signals vulnerability to a reversion to the mean, especially when fueled by a bubble-like momentum riding the wave of a popular narrative. As an index becomes increasingly concentrated, it not only invites the prospect of mean reversion but also introduces a myriad of risks, creating a strategic chessboard for active portfolio managers reminiscent of a Queen's Gambit.

The S&P 500 operates as a weighted-cap index, where individual stocks in the basket are proportionally represented based on their market capitalization. Traditionally, an equal-weighted S&P 500 index has showcased a 2.4 percent annual outperformance compared to its cap-weighted counterpart. However, in the last decade, the cap-weighted approach has surged ahead, outperforming by nearly 5 percent (Chart 2). Throughout much of stock market history, favoring portfolios skewed away from mega-cap stocks has proven lucrative for managers. Nevertheless, in the past decade, it has been a challenging endeavor. Yet, market participants would be smart to remember a fundamental lesson—over an extended time horizon, mean reversion is as undeniable a force as gravity. In the current landscape of heightened concentration, when mean reversion inevitably takes hold, it is the Active Managers armed with analytical skill and experience who will likely emerge victorious.

Magnificent and Misleading

The Magnificent Seven, gaining prominence in 2023, has orchestrated a decade-long market outperformance, reaching a staggering 60% pinnacle last year. The success was propelled by strategic transformations—Microsoft and Amazon reinvented themselves, while Apple, Alphabet, Meta, Nvidia, and Tesla dominated their respective industries. Medium-sized enterprises among them burgeoned into giants, and the already colossal ones ascended to titan status. The sustained outperformance of The Magnificent Seven has propelled the S&P 500 into a realm of intense concentration, currently comprising a formidable 28% of the entire index—surging over 200% higher than a decade ago. Such a profound shift away from diversification over a 10-year span is unprecedented in the market's history. The heightened concentration stems significantly from passive inflows, including those from 401K plans, streaming into the indices. Due to the cap-weighted nature of the index, an excessive proportion is allocated to the top tier, compelling underlying fund managers to acquire stocks even as valuations escalate to manic levels. This creates a self-reinforcing cycle, as evident currently, until a disrupting event occurs, such as a recession that leads to a deceleration or halt in contributions to passive funds.

The seemingly unbelievable outperformance of the Magnificent 7 underscores the shortcomings of the S&P 500 as a benchmark. If the intent of a benchmark is to impartially gauge a manager's skill, a market cap-weighted index proves impractical for active managers—especially as it grows more concentrated. The earlier-discussed underperformance of mega caps often prompts active managers to position themselves underweight these stocks. Consequently, during periods of significant mega-cap outperformance, active managers face a substantial headwind that adversely impacts their relative performance. Due to the impracticalities associated with market cap-weighted indices, we favor the Lipper benchmark for our client managed assets. This benchmark provides a more accurate representation of the dynamic landscape we navigate, incorporating a well-balanced mix of low-beta stocks paying dividends, a fixed income allocation, and a prudent cash position. This diversified approach aligns more closely with our investment strategy and reflects the complexities of the real-world market environment we operate within.

Despite their formidable run, signs of strain are emerging among The Magnificent Seven, now seemingly reduced to The Magnificent Five (Chart 3). Tesla's vulnerability has surfaced amid doubts about the feasibility of an all-electric future, while Apple falters with consecutive quarters of earnings misses. For the remaining quintet, idiosyncratic risks loom large. All five companies hinge heavily on the successful implementation and adoption of AI. Furthermore, four of them share a reliance on the same Taiwanese chip manufacturer, exposing them to direct revenue impacts of at least 20% should tensions escalate in the region with China. The once unassailable Magnificent Seven now grapple with nuanced challenges. Time will unveil whether they follow the path of fallible Nifty Fifty of the 1960’s or Dot Com darlings of the late 1990’s, as mega caps historically underperform significantly when at a substantial premium. When the US equity market diversifies, skilled active managers stand poised for a remarkable decade, where we will aim to provide our clients the opportunity to benefit from our meticulous allocation strategy, thoughtful timing, and healthy diversification.