26 Feb 2025
The founder of Modern Portfolio Theory, Harry Markowitz, famously described diversification as the ‘only free lunch’ when it came to investing. The quote is as relevant now as it was back in the 1950s.
The current uncertainties, especially geopolitically, highlight this simple, but sometimes overlooked, aspect to investing. There are the obvious ways of achieving diversification by holding different asset classes, however care is also needed within an asset class itself. For equities, especially in the US, broader market exposure is warranted to dilute down the concentration in a select number of mega cap companies.
The recent market volatility reflects several issues but has been focused on changes in the competitive environment surrounding artificial intelligence (AI). A number of AI beneficiary names in the US have come under pressure following the launch of the AI model from the Chinese company DeepSeek, which on the face of it has developed an algorithm that requires far less computing power to deliver the same results.
This release, and its meteoric rise in popularity, sent a shockwave through AI beneficiary names, most notably Nvidia (due to the production of its advanced chips used in many competitor AI models to DeepSeek), which experienced a circa 17% fall in its share price on the 27thJanuary, equivalent to a nearly $600bn decline in its market capitalisation. Whilst much of this value has been recovered since, this drop shows how fragile this sector can be. This point is particularly important for global portfolios as the growth created in the last few years has been linked to a narrow number of stocks, mostly focused on innovation and technology. The magnificent seven stocks in the US highlight this issue, although there are similar patterns across the developed world.
This leads us to question whether is it time for investors to broaden their outlook on developed markets, the US market in particular, and look further down the cap scale? In recent years, passives have dominated the US large cap market as it has been increasingly challenging for active managers to outperform an index. However, further down the cap scale active managers may offer better opportunities. There are many companies that are included in indices that have lacklustre fundamentals, and more compelling investments can be found.
So, is now the time to Make Active Management Great Again by focussing on the US market’s stock picking paradise? Where analyst research coverage is lower and there is a higher degree of domestic earnings which benefits directly from strength in the US economy? Where old fashioned stock picking can add alpha to investors’ portfolios? Data certainly supports this view – the further down the market cap you go in the US, the greater the percentage of active managers delivering alpha. One issue raised against investing in mid and smaller caps is liquidity risk, but this is less relevant in the US with smaller cap companies often c$5-6bn in size.
It does seem that there are opportunities for active managers, given higher valuations in certain stocks and sectors, but this is not the first time we have thought this in the last two years. The catalyst for change has been elusive and each time markets have broadened out in support of valuation anomalies, the momentum has faded and growth has reasserted itself. At some point this will stop being the trend, but no one really knows when it will change. This brings us back to diversification. Few of us can spot market inflection points or have the time to analyse market movements, so we delegate to investment professionals who we hope will lead us through the maze of options and choices.
Is now the time to be more active? It certainly feels like the signals are stronger in certain sectors and that we should be prepared for change.
We will just dust off our crystal ball to confirm …
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