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Smart diversification: European equities’ role as portfolio de-concentrators

For professional and institutional investors only

With global equities more than ever dominated by US stocks and US equities themselves increasingly skewed towards the tech sector, Niall Gallagher analyses the role European equities could play as portfolio diversifiers.

24 October 2024

It is no secret that US stocks have been the main drivers of global equities’ robust recent returns. Such has been the dominance of the US market, global equity portfolios have become increasingly biased towards US stocks, with US companies now accounting for a staggering 71.8%1 of the MSCI World Index (as at 30 September 2024). To put things in perspective, at the country level, Japanese and UK companies have the next biggest weightings, amounting to a mere 5.6%1 and 3.7%1 respectively of the world index.

Of course, the tech-heavy Magnificent Seven – Nvidia, Amazon, Microsoft, Meta, Alphabet, Apple and Tesla – have been core to US equities’ outperformance, helped by AI-related excitement and demand for megacaps.

But the consequences of this outperformance – and just how skewed global indices have become towards US stocks – could come as a surprise to many investors looking to maintain diversified global portfolios, particularly to those relying on a passive investment approach.

Source: MSCI, as at 30 September 2024

The US equity market is now uniquely concentrated in historical terms

The S&P 500 Index may still have approximately 500 constituents, but, in practice, concentration risk for index investors has never been higher. In market capitalisation terms, the top 10 constituents – that is the Magnificent Seven2, plus chipmaker Broadcom, Warren Buffett’s investment conglomerate Berkshire Hathaway and pharma Eli Lilly – now amount to 34.6%3 of the entire S&P 500 Index.

2* excluding Tesla (the 12th largest index constituent) but including both Alphabet A and C Class stock
3Source: S&P Global, as at 30 September 2024

US equity market is very concentrated

Concentration risk is at all-time highs

The top 10 largest US stocks as a percentage of total market capitalisation

 
Past performance is not an indicator of future performance and current or future trends.
Source: Société Générale Cross Asset Research/Equity Quant as at 30 Aug 2024.
The views are those of the manager and are subject to change.

Such has been the dominance of the tech-centred megacaps, as the below table demonstrates, passive index-led investing offers much less by way of stock-level diversification than many might expect from the US market.

 
Source: S&P Global, as at 30 September 2024

Plainly, when times are good for the stocks with the most dominant weightings, no index-based investor is going to complain about their gains. However, investors should at least be aware of the stock-level concentration risk in holding the US benchmark index, then decide whether they are comfortable with this level of concentration.

On the face of it, any investor uneasy about the present concentration risk in US equities might consider diversifying into global equities instead. However, closer inspection suggests that a global index-based approach could offer only limited relief.

Global equity indexes are now little more than US-lite

Concentration risk is at all-time highs: top 10 largest stocks as a percentage of total market capitalisation

 
Past performance is not an indicator of future performance and current or future trends.
Source: Société Générale Cross Asset Research/Equity Quant as at 30 Aug 2024.
The views are those of the manager and are subject to change.

Such has been the dominance of a limited number of US stocks that even global equity indices now include outsized allocations to the same US megacaps that dominate the major US indices. Nvidia, for example, has 6.8%4 weighting in the S&P 500 Index and a still-hefty 4.3%5 weighting in the MSCI World Index.

4Source: S&P Global, as at 30 September 2024
5Source: MSCI, as at 30 September 2024

And of the top 25 constituents of the ‘global’ MSCI World Index, 23 are US-listed – only Europe’s Novo Nordisk and ASML appear in this list, and only then in 21st and 24th place respectively. So much for diversification out of the US and into global equities – the global index is hardly offering the kind of diversification away from US tech-sector megacaps that some investors might be expecting.

Source: MSCI, as at 30 September 2024

Europe’s role as a US – and US-lite – diversifier

Investors aiming to improve diversification away from the heavily concentrated US market, and concerned that global indices may be more biased to the US than they would prefer, might do well to consider a role for European equities as a diversifier. In our view, a combination of attractive valuations, a broad range of leading companies with strong global franchises, as well as a lower stock concentration risk at the index-level and improved diversification at the sector level, highlight the appeal of European stocks.

Europe’s indices are less concentrated in megacaps

In the US S&P 500, the three biggest index constituents – Apple, Microsoft and Nvidia – have weightings of 7.1%, 6.8% and 6.3%6 respectively, and, as discussed previously, the top 10 index constituents amount to almost 35%7 of the entire S&P 500 Index. In contrast, European equities exhibit much lower levels of concentration; the top 10 constituents of the MSCI Europe Index have a combined weighting of just 21.7%8, while Novo Nordisk, ASML and Nestlé, the three biggest constituents, have weightings of 3.3%, 2.9% and 2.3%8 respectively. So the MSCI Europe Index is much less concentrated in megacaps than its US counterpart.

6Source: S&P Global, as at 30 September 2024
7Source: S&P Global, as at 30 September 2024
8Source: MSCI, as at 30 September 2024

Europe offers greater diversification at the sector level

The US information technology (IT) sector on its own amounts to 31.7%9 of the S&P 500 Index. Add in the communications sector, which includes tech-focused names like Meta and Alphabet, and the concentration amounts to 40.6%9 across just these two sectors of the 11 of which the index is comprised.

Sector exposure breakdown: Concentrated US (left) versus more broad-based Europe (right)

   
Source: MSCI, S&P Global, as at 30 September 2024

The tech-sector tilt of the US Magnificent Seven stands in contrast to the greater sector diversification of Europe’s so-called ‘GRANOLAs’ – GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, Sanofi and SAP, which span sectors such as healthcare, consumer staples, consumer discretionary and IT. Taken together, the healthcare (16.1%), consumer staples (10.8%), consumer discretionary (9.8%) and IT (7.5%)9 sectors amount to a combined weighting of 44.2% in the MSCI Europe Index. In the US, only a single sector, IT, at 31.7%10, has a weighting of over 13%, whereas Europe’s financials, industrials and healthcare top that threshold, emphasising Europe’s greater diversification at the sector level.

9Source: MSCI, as at 30 September 2024
10Source: S&P Global, as at 30 September 2024

Europe’s diversification extends to where corporates generate their earnings

More than ever before, European companies are beneficiaries of global economic growth. In fact, today Europe-listed companies generate approximately 60%11 of their earnings from outside Europe, with the US, Canada and Asia ex-Japan the main drivers over the last 15 or so years.

11Source Redburn, October 2023

European companies are exposed to global growth

Significant revenue and earnings gains from strong USD

 
Past performance is not an indicator of future performance and current or future trends.
Source: Redburn, October 2023.

European companies are now less dependent on the performance of their domestic economies, and now have truly global earnings exposure. Anyone needing convincing of this might care to consider why Germany’s DAX is setting all-time highs at a time when the German economy is performing particularly poorly. The reason is simple - for a company like SAP, the German market really does not matter that much. What truly matters is how SAP’s global software business is performing. And, as the global businesses behind many German-based corporates are generating attractive earnings, the DAX index is performing well.

One benefit of European stocks’ increasingly global footprint is that many of the European companies we invest in are real beneficiaries of major initiatives such as the US Inflation Reduction Act. For example, European businesses selling compressors into the US market are gaining sales in carbon capture and hydrogen generation applications. By investing in what we term Europe’s global winners, investors can potentially capitalise on major earnings drivers across international markets, with the US especially significant for many of Europe’s leading businesses.

Why a style-flexible approach makes sense in Europe

Despite the extreme stock-level concentration of major US indices at present, the US stock universe remains both broad and deep, so dividing the US market up into growth, core and value, and large, mid and small caps can make sense. Despite a proliferation of high-profile companies operating on a global scale and a total market capitalisation of over USD 15 trillion12, European stock markets cannot match the vast scale of the US market, hence it is more difficult to produce a pure value or pure growth portfolio in Europe. Therefore, in our view a style-rigid approach does not work to the same extent in Europe. So, given the nature of European stock markets, a style-agnostic approach is more appropriate, especially for those looking to capture the key thematic trends that we believe are set to dominate what we term the ‘new investment era’.

12Source: Statista, April 2024

To capitalise on themes such as the normalisation of interest rates, decarbonisation and the capex super cycle, and the rise of the Asian middle class, we believe investors need to look beyond traditional rigid ‘growth versus value’ approaches and instead be much more style flexible. If we are looking to build portfolios aiming to capitalise on the scale of diversified opportunities in Europe’s global winners, then we can best play these themes by investing in our favoured stocks across sectors such as banks, energy, industrial cyclicals, premium consumer discretionary/luxury and technology. And we believe that the diversified nature of the European stock universe provides active managers like us scope to build portfolios with the level of stock-specific risk we seek in line with our key investment themes as we aim to capitalise on Europe’s long-term global success stories.

We believe the lower stock-level concentration, greater sector-level diversification, an increasingly global earnings footprint and attractive valuations make European equities an interesting proposition for investors.

At the very least, in our view, European equities represent highly attractive diversifiers for those uncomfortable with their existing exposure to the highly concentrated US market, and the surprisingly US-biased global market indices.


Niall Gallagher manages European and Continental European equity strategies at GAM Investments

Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

The MSCI World Index captures large and mid-cap representation across Developed Markets countries. The index covers approximately 85% of the free float-adjusted market capitalisation in each country.

The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe*. With 415 constituents, the index covers approximately 85% of the free float-adjusted market capitalisation across the European Developed Markets equity universe.>

The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities, and includes 500 leading companies and covers approximately 80% of available market capitalisation.

Niall Gallagher

Investment Director
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