As the diversification offered by traditional equity-bond portfolios wanes, institutional investors concerned about concentration risk are looking to alternatives and other actively managed strategies to balance their portfolios while still achieving returns.
In the last few years, concentration risk has been top of mind for investors, given the current inflation backdrop, according to Philip Straehl, CIO for the Americas at Morningstar Wealth.
“What shifted the stock-bond correlations was the change in the inflationary environment in 2022 and 2021,” Straehl says. “It was a post-COVID-19 impact.”
Equity market gains have become more concentrated in a shrinking number of stocks, primarily those in the U.S. technology and artificial intelligence sectors. This also increases risk for investors, should sentiment shift for those “winners,” resulting in major drawdowns.
Long-term investors have, as a result, increased their allocations to liquid alternatives, such as convertible-arbitrage and merger-arbitrage strategies, Straehl says, to reach for diversification that is less correlated to the stock market.
Convertible-arbitrage strategies typically take long positions in convertible bonds and short positions in the same company’s underlying stock. Meanwhile, merger arbitrage can offer diversification by investing in companies going through a merger or corporate takeover.
“We also use other trading-based strategies that provide more uncorrelated returns relative to equities and fixed income,” Straehl says.
Within fixed income, investors are also gaining diversification through nontraditional bonds.
“We are thinking about the duration profile that we want in our fixed-income portfolio … and investing in yield curves that are not the U.S. Treasury,” Straehl says.
Morningstar sees opportunities in emerging markets bonds that are “broadly diversified” across markets.
“We’ve generally owned emerging market debt, but we own [it] at a higher rate and higher proportion now,” Straehl says. Overall, “thinking about alts and broader concepts of fixed-income allocation” are the “two most tangible ways we are looking at addressing diversification.”
Equities Exposure to AI
Large-cap equities and emerging markets equities are asset classes that present the biggest risk management concerns for investors in the current environment, according to Straehl.
“In emerging markets equities, you may get massive exposure to the AI sector. In our mind, the key is to be more selective,” Straehl says. “In the emerging market complex, we loved Korea around 18 months ago, but we think now we’re at a point where there’s clearly a speculative dimension to what’s driving these markets. We are focusing on Latin America, including Brazil, and China as far as emerging markets opportunities now.”
He says there is also a focus on contrarian bets in U.S. stocks.
“In the large-cap equities space, we are focusing on perceived AI losers, where we think the market may be penalizing them too quickly,” Straehl says. “We think there’s been an overreaction leading to stock sell-offs.”
Straehl points to companies such as Mastercard, Aon PLC and SAP, where shares have tumbled at various points this year.
For smaller institutional investors—such as endowments and foundations—that may not have the internal investment team or stock research capabilities of larger pension funds, Straehl says they may need to consider giving their equity managers breathing room to take a more active approach and stray from their benchmarks.
“I will say that for endowments and foundations, one way they might address concentration risk is making sure they partner with active managers that provide them with more diversification and less of a cap-weighted focus to large-cap and emerging markets equities,” Straehl says. “They would probably want to give their U.S. equity managers or emerging markets managers a bit more leeway to deviate from the benchmark to provide them that needed diversification.”
The weakening of stock-bond diversification is a “recurrent phenomenon” that is “usually, but not exclusively” caused by periods of high inflation, wrote Giuseppe Sette, the co-founder and president of AI investment analysis startup Reflexivity, in an email to CIO.
“Most importantly, it’s a transitory phenomenon,” Sette wrote. “In the short term, Sharpe ratios might suffer, [but] buying the deeper drawdowns of balanced stock-bond portfolios results in consistent excess returns over many decades.”
Investors Shift to Active Management
The S&P 500 Index has reached a historic high level of market concentration, with the 10 largest companies representing more than 40% of the index by market capitalization, according to research shared this year by Commonfund.
Concentration does not necessarily signify “poor future returns” for those handful of stocks, but “it can magnify portfolio distress in market downturns,” Commonfund analyst Haider Hassan wrote in a market commentary on this trend.
“Stock market volatility can be especially elevated given the crowding in the top 10 S&P 500 companies if there is a shift in the momentum powering them,” Hassan wrote. “This is precisely why a portfolio built with prudent diversification across asset classes, sectors and geographies can be better protected in downside scenarios as effects from price movements in the largest individual companies are less magnified.”
Due to concentration risk, nearly 40% of North American institutional investors say they are increasing their allocations to actively managed strategies, according to a recent Schroders survey.
“As uncertainty becomes a more permanent feature of markets, investors are not standing still,” the Schroders’ report stated. “They are prioritizing diversification, resilience and active decisionmaking to help capture opportunities and manage the risks created by more concentrated markets.”
Of more than 1,000 respondents globally, comprised of institutional investors and what the firm described as gatekeeper wealth managers, 287 were from North America, according to the Schroders report.
“This year’s findings highlight the breadth of challenges institutional investors are navigating today, from geopolitical uncertainty and evolving trade dynamics to AI-driven disruption and heightened market concentration,” Tom Darnowski, Schroders’ CEO of the Americas, said in a statement. “What’s striking is that investors aren’t responding by abandoning growth. Instead, they’re looking for ways to balance growth ambitions with greater diversification, income generation and portfolio resilience.”
Tags: active vs. passive, Artificial Intelligence, correlation, drawdown risk, geopolitical risk, Risk Management, Trade Tensions