The strong performance of US equities through the reporting season has created a practical rebalancing question for advisers. That’s whether portfolios that have benefited from the recent rally now carry more exposure to US equities, particularly mega-cap tech stocks, than intended.

The S&P 500 has rebounded sharply from its late-March low to trade near the upper end of its historical valuation range in recent weeks driven by US corporate earnings consistently beating consensus forecasts, according to FactSet.

“The S&P 500 looks to be on track to register earnings per share growth of 17%, which would be the highest rate in four years,” UBS wrote in a note toward the end of reporting season. “Against this backdrop of equity market resilience, we see an opportunity for investors to rebalance portfolios from a position of strength,” it said.

The rally spurred by the strong earnings season added the equivalent of US$10 trillion in market value from the S&P 500’s 20 March 26 low to mid-May (11 May 26) but also sharpened concentration risk.

Goldman Sachs Asset Management says the top 10 stocks now account for 36.5% of the S&P 500 by market capitalisation, led by Nvidia, Apple, and Microsoft.

That concentration has created a growing portfolio-management challenge, Goldman says. As mega-cap stocks take up a larger share of the index, investors may face greater volatility, less diversification and more exposure to potential over-valuation in a narrow group of companies. 

“Equity market concentration has reached historic levels in the US and emerging markets, driven largely by the outperformance of technology giants,” analysts at Goldman wrote. “This combination of elevated concentration and narrow market leadership poses a range of risks for investors, including greater sensitivity to earnings disappointment and the increased probability of a disorderly market correction.” 

They also noted that elevated concentration can make it harder for active long-only equity managers to add value, because portfolios become increasingly benchmarked against a small cohort of dominant stocks.

Valuations prompt diversification call 

Against the backdrop of fresh record highs in US and global equity markets, a number of asset managers are doubling down on diversification.

UBS called for investors to diversify portfolios to “reflect the broadening of earnings growth,” within US equities, citing consumer discretionary, financials, healthcare, industrials, and utilities, while maintaining “constructive” views on AI-linked areas of the market.

UBS analysts also advised investors to consider opportunities beyond the US for diversification, pointing to deeply discounted valuations across Asia-Pacific markets, including China, Japan, South Korea, and Australia.

The same diversification focus was the crux of a recent Vanguard note, “The great rotation: when valuations start to matter again,” reinforcing the case for advisers to revisit diversification after a prolonged period of US-led market gains.

“Against the current backdrop, our view remains that within the equity portion of their portfolios, investors would benefit from the diversification derived by leaning into more reasonably valued market segments, both US and non-US,” it said.

Vanguard added that many parts of the global equity market beyond mega-cap technology remain under-owned in portfolios.

“Whereas stretched valuations leave stocks vulnerable to a sudden business model disruption, the low expectations underlying low valuations can provide resilience -- and potential upside,” it wrote.

BlackRock also urged investors to review “big portfolio calls” more often as the mega force-driven transformation plays out, warning that while “mega-forces” continue to drive markets, “allocations made under the guise of diversification may be in fact be active bets.”

“As the transformation unfolds, traditional broad market indices can become more concentrated,” analysts wrote in its recent second-quarter global outlook piece, adding “What looked diversified on paper can become a large, implicit bet on how the transformation plays out.” 

Concentration risk as a portfolio issue

As part of a prudent portfolio review and rebalancing process, the recent US earnings season has given advisers a timely reason to test whether the portfolios that benefited from the rally are still aligned with the risks clients intended to take.

Advisers should routinely check whether client portfolios still reflect their intended asset allocation, sector exposure, currency position, and tolerance for concentration risk.

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