The stocks most fund managers won’t bet against

The investment gurus of our time are consistently scathing about the madness of the crowd. From Burton Malkiel to Warren Buffett, they have repeatedly warned stock market investors to be wary of herd mentality. Their words of wisdom are to do your own homework, look through the hype, and to back the companies you expect to outperform over the long term, irrespective of what the market as a whole thinks about them right now.

Here’s the thing, though. The madness of the crowd can drive outsized profits while it lasts. Buffett is right to warn investors about the dangers of blindly following the latest craze of the day; but there’s also danger in ignoring it – you’ll miss out on the gains that such crazes generate while they run their course.

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It’s a dilemma that worries fund managers too. Most managers will tell you their portfolios reflect rigorous in-house research – that each stock in the fund has been carefully selected on its own merits. But the truth is that some stocks are simply too big to ignore; a fund manager may not share the collective view of their prospects, but they will usually still want at least some exposure to them.

Risk management

“Some managers will therefore keep meaningful exposure even when they are not particularly positive about a company,” says Sheridan Admans, founder and chief investment strategist of the investment consultant Infundly. “That can be sensible risk management as it stops the performance of one large stock from overwhelming all their other investment decisions.”

In the UK, for example, the FTSE 100 index is, as the name suggests, an index comprising the 100 largest stock market-listed companies. But just seven of those companies account for around 40% of the index’s performance. Take a look at the list of the largest holdings of most UK-focused collective funds and these seven stocks – AstraZeneca (LSE:AZN), HSBC Holdings (LSE:HSBA), Shell (LSE:SHEL), Rolls-Royce Holdings (LSE:RR.), British American Tobacco (LSE:BATS), Unilever (LSE:ULVR) and GSK (LSE:GSK) – will appear over and again.

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Similarly, in the US, the “Magnificent Seven” technology companies are collectively worth around $22 trillion (£16.3 trillion) and account for around a third of the S&P 500 index, the benchmark meant to tell you how the whole US stock market is performing. The fortunes of Apple Inc (NASDAQ:AAPL), Alphabet Inc Class A (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), Meta Platforms Inc Class A (NASDAQ:META), Microsoft Corp (NASDAQ:MSFT), NVIDIA Corp (NASDAQ:NVDA) and Tesla Inc (NASDAQ:TSLA) therefore dominate the fortunes of the market as a whole, at least when looked at through the lens of its most visible index. US fund managers who do not focus on smaller companies feel obliged to hold these stocks. 

Concentration risk is also a problem in Asia

This isn’t just a Western phenomenon. Indeed, in some markets, it’s even more pronounced. In Asia, for example, the giant Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM) accounts for 58% of the MSCI Taiwan index – and for 15% of the MSCI Global Emerging Markets index. Almost any global emerging markets fund you buy will hold the Taiwanese chip manufacturer.

For investors, such dominance can be hard to escape. If you buy a low-cost index tracking fund, you’re buying outsized exposure to these very large holdings by definition – a passive fund tracking the S&P 500 might sounds as if it’s giving you exposure to a broad bucket of US equities, but a third of your money will be invested in just seven technology companies.

“In my view, the key question for passive investors exposed to these indices is whether they truly understand what they’re buying,” says Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Sits A Acc (B659XQ0), IFSL Marlborough UK Micro Cap Gr P Acc (B8F8YX5) and IFSL Marlborough Nano Cap Growth P Acc (BF2ZV04) funds. “Do they think they’re getting a beautifully diversified portfolio, or do they realise the extent of the concentration risk involved? I would love for everyone in the wider investment community to really grasp this issue.”

Even if you’re buying an actively managed fund, there’s a good chance it will also have sizeable holdings in these businesses. In theory, active fund managers get paid to pick and choose holdings on their individual investment merits. In practice, managers are often reluctant to move too far from the index, because this is the benchmark they’ll be judged against.

Betting against the Magnificent Seven

A US fund avoiding the Magnificent Seven is taking a huge gamble. If those companies subsequently generate good returns – as over large parts of the past three years – the fund will almost uncertainly underperform both the market as a whole and many of its rivals. Making the wrong call on just seven stocks out of hundreds of possible holdings across the market will have an enormously damaging impact if those seven stocks account for a third of the index.

For this reason, most US funds – and global funds too – will hold a reasonable chunk of their portfolios in the Magnificent Seven, even where managers are sceptical about future investment prospects. The same is true in the UK: most large actively managed UK stock market funds will have significant exposure to the likes of HSBC, AstraZeneca and Shell. They may have very different views about each of these businesses but in most cases, fund managers feel they must have at least some exposure to them.

That’s not to say active fund managers feel compelled to weight their portfolios towards these companies at the current index weighting in the market. A manager who is particularly bearish on AstraZeneca, say, might hold 5% of the fund in the stock, well below its 9% weighting in the FTSE 100.

However, the more the manager moves away from the index, the bigger the risk they’re taking; their performance will begin to diverge from that of other funds and the market as a whole, for better or for worse.

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Some managers are happy to confront this challenge. “I believe that always looking over your shoulder at the index, fretting about being too different, can ultimately drag on performance,” says Raheel Altaf, manager of the Artemis SmartGARP Glb Eq I Acc GBP (B2PLJP9) fund, which takes a stock-specific approach based on the manager’s own modelling work.

“That approach leads to an allocation that’s quite different to the cap-weighted index, but to our mind, this index-agnostic approach is not increasing investment risk but reducing it.”

Active share

Santa Barbara agrees, pointing to the high “active share” – a measure of how far a fund’s portfolio diverges from the benchmark – of the funds he runs, although he also concedes that this can drive a returns profile that looks different to that of his peer group.

“It’s true that the past few years have been a great time to be in large companies, thanks to inflation, the cost of living, higher taxes and the appeal of a more geographically diversified revenue base – which is a feature of all the big FTSE 100 companies, for example,” he says.

“But that doesn’t mean this backdrop will persist forever. One of the reasons we’re comfortable with a far less constrained approach is that we believe it’s hard to have a long-term, sustainable edge in the mega-cap space.”

For individual investors, the key is to recognise the debate here – to understand just how brave a particular fund manager is prepared to be and then to decide whether that appeals.

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You may feel that since you’re paying for active fund management – through fees that are significantly higher than those in a tracker – that’s what you want, rather than an approach that simply shadows the index but is more expensive anyway. Fair enough, if you’re making a conscious choice to back a more contrarian manager – but if returns disappoint, the getting-what-you-pay-for approach may begin to feel a little hollow.

“A benchmark-aware fund with low-to-moderate tracking error, which measures how differently it performs from its benchmark, can still add value through a series of smaller stock and sector decisions,” points out Admans.

“By contrast, avoiding or significantly underweighting a major index constituent is a much bigger active decision. It may show greater conviction and a willingness to move away from the benchmark, but it also increases the risk of falling behind if that stock continues to perform strongly. It demonstrates a willingness to take more benchmark risk but does not necessarily indicate better judgement.”

There isn’t a right or wrong answer, argues Admans, but investors do need to be familiar with measures such as active share, tracking error and portfolio concentration, as well as traditional considerations such as charges and long-term results. “Neither approach is automatically better: staying relatively close to the index can be prudent, while a large underweight can be justified when the manager has a clear investment case and is prepared to accept the consequences,” he points out.