The key risks everyone on Wall Street are talking about

As the chart above shows the US equity market is twice as concentrated as it was during the peak of the dot-com bubble in 2000. Goldman Sachs wrote earlier this year a note on US equity market concentration in a longer historical perspective showing that the market has not been this concentrated since 1932. This fact alone should make every individual investor to pause for a second and think about portfolio risks and diversification. Am I having too much exposure to magnificent seven, Nvidia, or AI stocks in general?

Professional investors have diversification rules and so should individual investors

When we talk about diversification it can often be abstract for most individual investors. Concepts like mixing bonds and equities is smart and do not “put all your eggs in one basket” are understandable, but can it be more concrete?

Professional investors that want to create an UCITS* fund to manage assets on behalf of individual investors are regulated by strict and concrete diversification rules. As these rules apply for professional investors they should be considered as a good yardstick for individual investors as well. Here are the two most important diversification rules in the UCITS framework:

1. Single issuer limit: A UCITS fund cannot invest more than 10% of its net assets in transferable securities or money market instruments issued by a single issuer.
   
   
2. Aggregate issuer limit: Investments exceeding 5% of the fund's net assets in any single issuer must collectively not exceed 40% of the fund’s total net assets. This is known as the "40% rule".

These two rules are very concrete and rules that individual investors should take note of because they ensure a minimum level of diversification. Investors that do not have enough funds to have sufficient diversification across single stocks should consider what is a called a “satellite” approach. This approach is simple. You invest in a cheap ETF index tracker on global equities, the MSCI World Index, and then you add maybe one or two single stocks on the side. By doing this you fix the diversification issue while investing in companies you like and think will do well in the future, but you avoid taking a lot of company specific risks.

More insights on diversification check out our diversification universe for inspiration and knowledge on why it is important and actions you can take.

* UCITS (Undertakings for Collective Investment in Transferable Securities) funds are highly regulated vehicles in the EU designed to ensure a high level of investor protection. Diversification rules for UCITS funds are strict to limit exposure to any single issuer or group of issuers and to spread risk effectively.

Is there a disaster waiting to happen?

Alongside the rising equity market concentration another associated risk is building in financial markets and it is on everyone’s lips these days. It is the unusual calmness of the US equity market and a particularly option strategy which is reinforcing this calmness and smooth returns. Have we not seen this before? Yes, in 2017 and early 2018 before the big VIX blowup and sharp equity selloff in February 2018.

The S&P 500 has not experienced a single-day decline of more than 2% since 21 February 2023 and we have only had 8 trading days with a single-day decline of more than 1% since the current bull market began on 27 October 2023. This is quite extraordinary, but also something we have seen before. The subdued market volatility is like compressing gas in canister. At one point the pressure becomes too high and something cracks.

One of the biggest risks in the market next to the equity market concentration is a particular options strategy called the “dispersion trade”, which our options strategist Koen Hoorelbeke has written about in his recent note Smart Investor: Hidden dangers beneath the surface of a calm market. The dispersion trade is simply trades involving shorting VIX futures and going long individual call options on various stocks with potential catalysts for increased volatility like earnings, FDA approval or other company specific news. The trade works if index volatility (VIX) remains low (right now it is historically low) while the volatility of the individual stocks goes up. This trade has become extremely popular on Wall Street and it has worked well. In fact, it has worked so well that many agrees that too much money is now chasing this strategy, which is always a dangerous sign.

One of the key ingredients of why this trade works is the low correlation between stocks, which is the same as high dispersion, which means that if say the technology sector has a bad trading session then another sector such as energy might have a good session. This is the low correlation and it ensures that the index volatility remains well behaved and thus making the trade work. The problem is that the very low correlation environment is now at an extreme we have not observed since 2006 which is often a sign that something has gone too far.

At some point we get an event (it could be Nvidia missing earnings estimates, a string of bad macro figures or some geopolitical trigger) which sets off a broad-based selloff in equities which then takes correlation higher. This in turn might trigger a big jump in the VIX Index and then suddenly this big options trade on Wall Street most be unwound quickly. With equity market concentration as high as it is the whole unwooding might be amplified and cause quite a havoc in equity markets. It is almost impossible to predict when things could unravel, so the only sensible thing to do is to think about diversification, so that the portfolio can weather the next jolt of equity volatility.

Below are some other related commentaries we have done on the same subject.

• Investing with options - securing your tech stock gains with simple hedging strategies 1/2
• QO: New extremes and a challenging opportunity
• Podcast: Will this be the end of the magnificent seven?

Previous notes on asset allocation and macro

• French election: Is this a new Meloni moment for Europe? (24 June 2024)
• US rate cut seems distant as inflation report looms (10 June 2024)
• Commodities setback, investment drought in mining, and EM elections (3 June 2024)
• The inflation conundrum and private equity party (27 May 2024)