Owning a global equity fund – or several different funds – can feel like diversification. But beneath the labels, investors may be making much bigger bets on the same companies and themes than they realise.
You might own hundreds, perhaps thousands, of companies through your investment portfolio. On paper, that sounds reassuringly diversified. But look a little closer.
Five companies or six countries?
By the end of July, just five US companies (Nvidia, Apple, Alphabet, Microsoft and Amazon) accounted for approximately 18% of the whole global stock market as represented by the MSCI All Country index.
That is roughly the same weight in the index as every stock in Japan, Taiwan, the UK, Canada, China and South Korea combined!
Think about that. An investor buying a fund designed to track companies across the world could have as much riding on five businesses as they do on six major equity markets.
There is nothing inherently wrong with owning those companies. It’s their success that’s driven their growth. But it does raise an important question: are investors as diversified as they think they are?
More success, more influence
Market-cap-weighted indices have a simple characteristic: as companies become more valuable, they become a larger part of the index.
That has worked particularly well while the world’s biggest companies have delivered strong returns. But it also means portfolios can gradually become more concentrated without investors actively choosing to make them so.
And this isn’t just a US phenomenon.
The five largest companies represent approximately 29% of the US market, 37% of the UK and 33% of emerging markets.
So, investors can spread money between different markets and funds yet still find that a relatively small number of businesses have an outsized influence on their returns.
Three funds. Three regions. One big bet?
There is another layer to the concentration story that is perhaps even easier to miss.
Imagine an investor owns a US equity fund, a global equity fund and an emerging-markets fund.
Three funds. Different labels. Different geographical exposures. It certainly looks diversified.
Look underneath the hood, however, and all three could be exposed to different parts of the same economic story.
The US allocation likely contains the technology giants investing heavily in artificial intelligence. The emerging-markets allocation may have significant exposure to Taiwanese and Korean companies supplying the semiconductors and memory chips AI requires. And the global fund may own both.
Taiwan now represents just over a quarter of the MSCI Emerging Markets Index, while technology accounts for nearly 37%. TSMC alone represents around 58% of Taiwan’s market, while Samsung Electronics and SK Hynix together account for around 62% of South Korea’s.
An allocation labelled “emerging markets”, therefore, may increasingly be influenced by the fortunes of the global semiconductor and AI cycle.
Concentration is easiest to ignore when it’s working
None of this feels particularly worrying when the biggest companies keep going up.
Indeed, concentration can be a powerful tailwind. The larger the winners become, the more a market-cap-weighted index owns of them.
It is when sentiment changes that the other side becomes apparent.
July offered a reminder in Korea, where concerns about the scale and sustainability of AI-related capital expenditure put pressure on parts of the semiconductor and technology sector. Because a handful of these businesses have become such large components of their domestic and emerging-market indices, weakness in relatively few stocks can have a disproportionate impact on the wider market.
Even exceptional businesses can create portfolio risk if too much of an investor’s future return depends on the same handful of outcomes.
Diversification doesn’t necessarily mean just selling the winners
The answer isn’t necessarily to sell the world’s largest companies.
Market concentration can persist for long periods and reducing exposure simply because a company has become large can mean missing further gains.
The more useful question to ask is: what is actually driving the risk in your portfolio?
True diversification means owning investments that can succeed for genuinely different reasons.
That might mean complementing market-cap-weighted equities with investments driven by different factors, such as value-oriented companies or smaller businesses. It could mean more selective emerging-market exposure or looking beyond equities to areas such as fixed income or alternatives.
Active management can also play a role in concentrated markets. Unlike an index, an active manager isn’t required to own more of a company simply because it has become bigger, allowing them to look elsewhere for opportunities or reduce exposure where they believe concentration has become excessive or where the investment story doesn’t justify owning in such a big size.
Diversification still means spreading risk. But working out whether you have actually achieved it may require more work than simply counting the number of funds you own.
Look underneath the labels. Ask which companies dominate your investments, which industries they depend on and, crucially, what needs to happen for them to perform.
Because owning five different funds isn’t necessarily diversification if all five ultimately need the same thing to go right.
Ella Davies is multi-asset fund manager at Schroders. The views expressed above should not be taken as investment advice.