Indexing firm, Scientific Beta, has made the case to switch or stick to diversified stock exposures despite the ongoing dominance of US mega-cap companies.
In a new paper, Scientific Beta authors Daniel Aguet and Felix Goltz, argue that market concentration moves in cycles with periods of mega-cap underperformance inexorably following sustained runs at the top.
The study back-tested the performance of five variously constructed diversified portfolios and four “different risk-based approaches” during periods of low and high US stock market concentration dating back to the 1970s.
“When market concentration was extremely high, the subsequent outperformance of diversified strategies was not only high on average, but also very consistent,” the paper says. “The outperformance of diversified strategies when investing during periods of extreme concentration ranged from around six per cent per annum in the best case to around two per cent per annum in the historical worst case.”
According to the Scientific Beta analysis, the current basket of US mega-caps, colloquially known as the ‘magnificent 7’, is more expensive on a price-to-earnings gauge than in 90 per cent of the periods in the study since the 1970s.
Subsequent to such mega-cap valuation highs, diversified portfolios outperformed across a range of 3 per cent to 7 per cent, the study found.
“There is no historical precedent for diversified strategies underperforming over ten-year periods following expensive mega-cap valuations,” the report says.
Aguet and Goltz – respective Scientific Beta deputy chief, and, research director – also argue that the “inevitability” of market competition and “mean reversion of profits” will eventually dethrone this generation of mega-cap kings in line with historical precedents.
With the mega-cap market stranglehold loosening a little this year, the paper suggests investors might “tactically allocate to diversified strategies”. And Scientific Beta cautions those investors who “have maintained diversification and underperformed in recent years” not to abandon the strategy now.
“Historical market cycles have shown that such diversified investors are rewarded for their patience, while those who chase yesterday’s winners have often arrived just in time for the cycle to turn.”
Scientific Beta is a specialist index provider and research firm owned by the Singapore Stock Exchange.