Increased Stock Market Concentration: Risk or Opportunity?
February 10, 2021
With the stellar growth of a handful of large-cap companies, an index can become more concentrated, with more of the performance and risk driven by an increasingly smaller number of stocks. This may increase risk for active managers who lack exposure to those names and to indexed portfolios whose returns lag those of the market leaders, such as the FAANG stocks in the U.S.
To assess concentration, investors can look at the percentage of the largest companies in the index. But it may be useful to also look to a finer measure called the effective number of stocks. This indicates how many stocks are “effectively” driving an index vs. the total number of index constituents. The bigger the difference between the effective number and the number of index constituents, the more concentrated the index.
For example, based on the weights of the top-25 constituents in the MSCI North America Index, concentration as of Nov. 30, 2020, was lower than it was in the late ‘90s. The effective number of stocks, however, shows great similarity, with higher concentration levels over both periods. As the effective number of stocks has fallen and the proportion of the top 25 has gone up in recent years, investors focused on individual regions or countries may find they are less diversified than they thought.
Weights of Top-25 Constituents (%)
Effective Number of Stocks
Data from Dec. 30, 1994 to Nov. 30, 2020.
The effective number of stocks is a standard measure for portfolio concentration and is calculated as 1/(sum of stock weights-squared).