Index concentration - the hidden risk lurking in your portfolio

THERE were plenty of reasons why 2022 was a painful year for stock market investors.

A war in Europe fuelling rampant inflation, and rapid interest rate rises in response, was a headwind for most companies barring those directly benefitting from the turmoil.

But even with that heady mix, returns for many stock portfolios looked particularly bad. If the correspondence we get from investors is anything to go by, drops of 20% or even 30% were all too common.

Part of the reason is that the companies that lost the most last year were also the companies that investors held in the largest weightings. The highest-profile example of these were the tech names that dominate the US stock market. Anyone buying broad exposure to the US would have ended up with high proportions of these companies, so their fall last year led to big losses overall.

This is always a risk if your investments correlate to market indices, as most funds do to some degree or other. But there’s reason to think that the risk of your investments becoming concentrated in just a few stocks is rising - as highlighted by research from earlier this year by Schroders, the asset manager.

It showed that, by the end of 2022, the top 5 stocks in the US accounted for 17.9% of the overall US market. Other markets see the same - or higher - concentrations among their top companies, but the US is worth focussing on because the US market itself takes up so much of the global stock market. Anyone with a broad exposure to world shares will have a high concentration in the US, and therefore this small group of companies, all of which come from the technology sector.

The Schroders research goes on to show that a portfolio of just the seven largest American companies would’ve returned a minus 40% return last year, compared to a fall of just 14% for the rest of the US market. That goes some way to explain why so many investors saw such big falls last year.

The question is - can you do anything about this index concentration risk, and would you want to if you could?

If you attempt to balance your investments away from the index, the return you get will be less correlated to it. Fine if you get your choices right, but painful if you don’t.

That said, there might be good sense in running the rule over your portfolio to identify where the concentration risk lies. For example, you may have some passive exposure to major indices in the UK or US - that means a concentration of the leading companies in those markets. If you were to then add an active fund or investment trust which happens to specialise in the same types of companies that lead those markets, you will be concentrating your risk even more.

The Scottish Mortgage Investment Trust was a recent example of a popular active fund that doubled up the exposure to tech for many investors.

It could be smart to consider funds which balance out your risks. Increasing your exposure to smaller stock markets, or to smaller companies within the same market, will have this effect.

The Select 50 is our list of favourite funds, selected by experts. You can search according to regions and sector to find funds that complement your existing core holdings.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. The shares in the Scottish Mortgage investment Trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.