Investors backing US equities are vulnerable to a correction across just five stocks. Should this be a concern for schemes with a focus on passive equity strategies?
For a few months this summer, it appeared that US tech was rising from one high to another. The big five of the sector in the US – Apple, Microsoft, Alphabet, Amazon and Facebook – increased their market capitalisation by more than 50% in the first half of 2020, now covering a combined market value of $6.4trn (£4.8trn).
Analysts remain divided as to what drove this rise, but the combination of large-scale quantitative easing combined with the perceived resilience of the technology industry to Covid risks are major drivers.
The rise of these five tech giants has left a deep mark on US equity indices, particularly those with a tech bias, such as the NASDAQ100. The S&P500, which is also market-cap based, has seen a dramatic increase in concentration, with the big five tech stocks accounting for a fifth of the overall index, which has returned 25% year-to-date, as of late August.
If the performance of the top 10 firms had been deducted, the S&P500 would have performed -3.5% in the year to date.
But big tech’s fortunes turned suddenly in early September where, within a single trading day, 8%, or $180bn (£135.4bn), was written off Apple’s stock market value.
The sudden change in fortune is likely to have been driven by trades in the derivatives markets, suggesting that tech stocks could face further swings in volatility. According to CBOE Options Exchange, there has been a sharp surge in call options for US equities, while demand for put options has remained muted.
This suggests that an underlying wariness among many investors about the sustainability of the recent market rout.
A share of these call options was placed by Japanese asset manager Softbank, which holds $4bn (£3bn) in call options, the Financial Times revealed. However, the Commodities Futures
Trading Commission reveals that leveraged funds account for the lion share of short trades against the Nasdaq while a majority of asset managers and institutional investors are net long against the tech heavy index.
Investor caution was also reflected in the CBOE Volatility Index for the Nasdaq, which measures investor expectations of volatility for the tech heavy index. CBOE volatility for the Nasdaq
and S&P500 rose above 30 basis points at the beginning of September, in sharp contrast to the record high levels booked by the underlying indices.
This surge in volatility could have an impact on UK institutional investors. While the average UK scheme has only 17% of its portfolio invested in equities, according to Mercer, this varies significantly, with defined contribution (DC) schemes and less mature defined contribution (DB) schemes featuring a significantly higher allocation to equities.
Due to the charge cap on fees, DC funds tend to have most of their equity assets invested passively. Consequently, the big five feature prominently in the average portfolio of many DC default funds.
Examples include Nest’s 2040 Retirement Fund, where Microsoft, Apple, Amazon and Alphabet are the top four holdings of the default fund’s equity portfolio. The Nest Higher Risk Fund, which targets the relatively younger scheme membership of the state-backed auto-enrolment provider, has about 70% of its portfolio invested in equities, with the big five again prominently reflected here.
Smart Pensions’ default funds, such as the Smart Growth Higher Risk Fund, also feature the big five tech firms as their main equity holdings.
Many institutional investors have opted to approach US equity investments on a passive basis, mindful of the fact that the market is widely seen as efficient. Indeed, by the end of last year, assets managed in US-based index and passive funds overtook actively managed strategies for the first time.
But there are notable exceptions. Local Pension Partnership, a local government scheme pool, has allocated more than £5bn of its portfolio into an actively managed Global Equity Strategy.
As of July 2020, Apple, Amazon and Microsoft featured as its top underweight stock picks. While the move might have been hard to justify at the time, it might well pay off over the coming months.