Looking for diversification? Look beyond the usual suspects

Investors in multi-asset funds will be familiar with the power of diversification, ‘the only free lunch in investing’. Spreading your risk across a variety of assets with different characteristics in a range of political and economic regimes – giving your portfolio exposure to a spread of future cashflows – provides valuable insurance against the unexpected.

Yet while most multi-asset funds deliver instant diversification on an asset-class level, the increasingly concentrated nature of capitalisation-weighted stockmarket indices suggests that investors may need to look beyond ‘the usual suspects’ if they are to reap the benefits of diversification on a company level.

A narrow group of companies and investment themes have progressively come to dominate global indices

Over the past decade, a handful of interrelated themes have characterised global markets:

• The outperformance of US equities.
•  Hopes that generative AI will permanently transform the earnings potential of a group large, technology companies.
• The outperformance of ‘growth’ stocks relative to their ‘value’ counterparts.

One result is that US stocks now account for almost 70% of the global equity market by value (up from around 40% in 2008)¹. You might reasonably argue that doesn’t matter: America’s technology giants are, in reality, global – rather than local – businesses.

Of potentially of greater concern, however, is that the 10 largest stocks by weight in global index today appear to be thematically linked.

To varying degrees, the lofty valuation multiples of all of these businesses are being supported by the assumption that generative AI has permanently transformed their earnings potential. The problem, however, is that if you allocate your capital to these businesses in anything approaching their index weightings (together, these 10 stocks account for around a quarter of the MSCI AC World Index) you will have assembled a lopsided portfolio whose returns are skewed towards one type of business.

If your equity portfolio resembles the index, you’re taking a significant bet on technology, on US growth stocks and on AI. That bet might pay off – but it should not be mistaken for genuine diversification. Given the narrowness of markets, investors may be at risk of over-allocating to a small group of stocks while simultaneously under-allocating to other potential sources of return.

There are other (profitable) themes and sectors to follow

The good news is that exposing your equity portfolio to a variety of future cashflows has not necessarily meant sacrificing returns in the near term; it is possible to harvest attractive returns from global equities without placing an outsized wager on US mega-cap growth stocks. In 2024, for example, investors could have enjoyed market-beating returns by investing in dividend-paying (and reasonably valued) stocks in such diverse areas as:

• Gold miners (In sterling terms, Canada’s Kinross Gold returned 59% in 2024).
• Enablers of the energy transition (Germany’s Siemens Energy returned 299%).
• Banks and insurers (South Korea’s KB Financial returned 43%).
• Engineers (Japan’s Mitsubishi Heavy Industries returned 149%).
• Defence contractors (Germany’s Rheinmetall returned 106%) .

The depth and diversity of the world’s equity markets should make them a core hunting ground for multi-asset investors. But before you commit too much of your financial future to a narrow group of the most widely held (and often expensive) stocks, consider taking a wider view – and looking beyond the usual suspects.