The Heightened Risk of Passive in U.S. Large-Cap Growth
Think twice about passively going along for the ride in a concentrated market
The Russell 1000 Growth Index has reached the highest concentration level in its 40-year history. Most people look to indices as a reasonable barometer of diversified exposure to a given asset class. But, in U.S. large-cap growth, this is arguably not the case.
It’s Getting Crowded in Here
As a proxy for the U.S. large-cap growth market, Figure 1 depicts the weight of the five largest Russell 1000 Growth Index constituents since the Tech Bubble in 2000, the last instance at which the top five holdings in the benchmark were as comparably high as they are today.
Figure 1: % Market Value of Russell 1000 Growth Index Top Five Constituents
Source: Bloomberg. Data from 3-31-2000 to 6-30-2023. Includes observations of top 5 holdings in the Russell 1000 Growth, rebalanced quarterly.
Currently, ~40% of the Index’s market value is accounted for by the top five holdings—Apple, Microsoft, Amazon, NVIDIA, and Tesla. The factors behind this unusual phenomenon are varied in our opinion. The generally low interest rate environment over the past decade, breakthrough innovations, the emergence of platform businesses, and winner-take-all (or most) market dynamics are all possible explanations beyond this piece’s scope.
2023: A one-two punch of concentration and narrow markets
In the first half of 2023, the high level of concentration and strong performance from the Index’s largest weights resulted in very narrow market performance. In 1H23, Apple, Microsoft, NVIDIA, Amazon, and Tesla accounted for 64% of the Russell 1000 Growth Index’s return, as shown in Figure 2.
Figure 2: 64% of the Index Return from Five Stocks
Source: Bloomberg. Reflects top five contributors to the Russell 1000 Growth Index return from 12-31-2022 to 6-30-2023. Past performance cannot guarantee future results.
The average return of all stocks in the Russell Growth Index during that period was 15.3%1, roughly half of its headline 29% YTD return. With just 23% of Index constituents outperforming the overall Index in the first half of the year, active managers likely found it challenging to keep pace with the benchmark without a substantial weighting in the top five holdings.
Possible Pitfalls of Passive
Experience has shown us that consistent earnings growth year after year drives share prices. However, overpaying for growth that proves to be less durable adds another layer of risk. We think many would acknowledge that Apple, Microsoft, Amazon, NVIDIA, and Tesla are among the most competitively advantaged companies worldwide. At the same time, this does not mean that each of these companies individually offers an attractive risk/reward at this point in time. And therein lies the risk for investors, based on our research. The large collective weight of these five businesses in the Russell 1000 Growth Index means that passive investors will see their prospective returns heavily influenced by the performance of these holdings.
If history is a guide, then investors would be wise to take a more nuanced approach, in our opinion. As noted previously, the last instance in which the Index was this concentrated occurred in June 20002. When the Tech Bubble burst in the early 2000s, the concentration in the Russell 1000 Growth Index (using the top five holdings as a proxy) declined for a prolonged period until it bottomed eight years later in March 2008.
Figure 3 shows the individual manager excess returns of the eVestment U.S. large-cap growth peer universe. Over this period of peak-to-trough concentration, the median U.S. large-cap growth active manager outperformed the Russell 1000 Growth by 4.8% annualized, gross of fees, and over 90% of active managers outperformed.
In other words, as the concentration of the Index’s top five holdings slowly deflated between 2000-2008, this period proved to be a favorable environment for active growth managers. The most likely explanation for this, in our view, is that active managers weren’t anchored to the top weights in the Index like their passive brethren, as those top weights collectively underperformed the benchmark.
Figure 3: Annualized Excess Return of U.S. Large Cap Growth Active Managers, 6-30-2000 to 3-31-2008
Source: eVestment U.S. large-cap growth universe of active managers. Data shown 6-30-2000 through 3-31-2008 to capture the unwinding of extreme market concentration. Blue bars are individual manager excess returns gross of fees, comprising 134 data points; the median manager excess return is denoted by the green line.
We are not suggesting that one should categorically avoid or underweight the top five Index companies. But history suggests that the high level of concentration among the top holdings in the Index may not persist. If this is true going forward, it implies that some of these large Index positions will underperform. In our opinion, this argues for a more active investment approach because passive benchmark investors may be unwittingly accepting an unfavorable risk/reward scenario.
More Space for Active Management
Today, passive investors are effectively betting on the go-forward success of a small subset of companies that, in some cases, may offer a less attractive risk/reward trade-off than they realize. Previous market history illustrates the pitfalls of being anchored to a top-heavy index. By contrast, active management may be well positioned to navigate quick shifts in market dynamics should the next decade look different than the last.
Important Disclosures
1 Source: Bloomberg. Data from 12-31-2023 to 6-30-2023.
2 Source: Blomberg. Data examined from 3-31-2000 to 6-30-2023.
This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of August 2023 and may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness, or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.
This should not be construed as a recommendation to purchase, hold or sell any particular security. There is no assurance that any securities discussed herein will remain in the portfolio or that the securities sold will not be repurchased. The securities discussed do not represent the entire portfolio. Actual holdings will vary depending on the size of the account, cash flows, and restrictions. It should not be assumed that any of the securities, transactions or holdings discussed will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. A complete list of our past specific recommendations for the last year is available upon request.
The Russell 1000® Growth Index is a market capitalization weighted index that measures the performance of the large-cap growth segment of the U.S. equity universe. It includes Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The index is maintained by the FTSE Russell, a subsidiary of the London Stock Exchange Group.
The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index.
The Tech Bubble was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-based companies in the late 1990s. During this period, the S&P peaked in Mar-2000 and bottomed in Oct-2002.
