The underperformance of the mega-cap names in the U.S. so far this year underscores the need for broader diversification within and across equity markets. Diversification remains the most effective tool to mitigate concentration concerns.
In Brief
- There are many strategies for managing the concentration risk in equity markets. However, the most effective remains diversification both within equity indices and across markets.
- The falling correlation of stock returns, combined with a wider-than-average dispersion in valuations create opportunities for active stock selection.
- The benefits of regional diversification are starting to appear, but lower relative valuations should not be the sole motivation for an increasing global equity allocation to non-U.S. markets.
A game of concentration
Equity concentration has reached high levels, raising concerns amongst investors about the potential for accelerated market corrections or increased volatility. This concern is not unfounded, as the top 10 stocks in the U.S. account for 37.2% of the S&P 500 - a higher share than at any point since 1996. Additionally, the U.S. weight with the broad MSCI AC World index of emerging and developed markets has risen to 66% from its most recent trough of 41% in 2009.
The challenge in assessing the risk posed by rising market concentration lies in the relatively constructive backdrop for risk assets. The underperformance of the mega-cap names in the U.S. so far this year underscores the need for broader diversification within and across equity markets. Diversification remains the most effective tool to mitigate concentration concerns.
Index diversification
Highly concentrated markets are often more volatile, and pockets of increased valuations may contribute to this volatility. The current concentration in the U.S. market is in the top decile since 1996, a period historically associated with higher realized market volatility (Exhibit 1). However, even if more volatile on average, the severity posed by a concentrated market may be less than assumed if the correlation between stock performances is lower.
A low correlation in returns between companies can offset some of the possible downside risks, since not all stocks would move in the same direction or with the magnitude in a broader market drawdown. The correlation of returns between the top ten companies in the S&P 500 and the rest of the market has been steadily declining and is at its lowest level since 2009 (Exhibit 2).
Successful investment strategies often rely on a consistent and repeatable process to deliver above-market returns. This is very different to an investment strategy that relies on the same sectors and stocks for repeatable returns, and which may ultimately prove to be a less successful strategy. Innovation tends to generate new technologies, products as well as lead to new markets that can impact market concentration and cause shifts in market leadership.
The low correlation of stock returns, combined with a wider-than-average dispersion in valuations create opportunities for active stock selection over passive benchmark approaches, enhancing equity diversification.
Investors may opt to diversify their exposure to the technology, artificial intelligence (AI) and adjacent stocks by exploring other growth sectors, such as healthcare, which may be a beneficiary of AI adoption or areas further down the AI value chain. Alternatively, barbell-style strategies can be considered, combining high-quality companies that have already performed well with those that have lagged but may now have an improving outlook.
The rotation within the U.S. equity market based on sector performance suggests that this is already underway. U.S. mega-caps posted remarkable earnings growth in the fourth quarter of 2024, but the rest of the market is catching up. Earnings growth for the seven mega-cap stocks was 30.3% year-over-year (y/y), while the rest of the market saw an earnings growth of 14.6% y/y. Although this gap is still wide, it is expected to narrow in the coming quarters. For 2025, the other 493 names in the S&P 500 are expected to deliver 60% of the overall market earnings, an almost complete reversal from 2024 (Exhibit 3).
Global diversification
In 2025, investors have begun questioning the investment thesis underpinning U.S. exceptionalism. The strong returns from U.S. equities in 2023 and 2024 reflected superior market and economic fundamentals, and strong earnings growth led by tech related profitability, justifying rising valuations. While many of these factors remain intact – solid corporate fundamentals, higher return on equity and a still robust earnings outlook – the ability to continue to beat market expectations and sensitivity to high valuations means investors could look for relatively better valued opportunities in other markets.
Valuation should not be the sole motivation for increasing global exposure. Some non-U.S. markets have already started to re-rate this year on better earnings prospects (Exhibit 4). A more moderate tariff policy and optimism around AI have supported Chinese equities while European markets have been positively influenced by prospects of a Ukraine-Russia peace deal, a more supportive fiscal stance across the region, and growing consumer confidence that could fuel domestic consumption.
The benefits of broader regional diversification are starting to appear but increasing non-U.S. global equity allocations still require an active approach. The impact of tariffs will be felt unevenly across regional markets and sectors, and investors will need to differentiate between what represents a value opportunity and those that may be “cheap for a reason.”
Investment implications
A higher weightage to a small number of companies is not a clear signal of overall higher levels of market risk. While a prolonged period of elevated equity returns and high valuations might create the right conditions for a market correction, a larger equity drawdown or bear market would likely require a sharper decline in the earnings outlook potentially driven by a developing recession scenario.
There are several themes in the investment world that we can expect to persevere, such as the growing use of AI, and those that are reestablishing themselves, like the diversification benefits of holding bonds. Investors may have become overly optimistic about some and too pessimistic about others, creating an opportunity to diversify within market indices, across geographies, and among asset classes to improve risk adjusted returns.