AI concentration craze skews returns

Ongoing investor interest in artificial intelligence (AI) has posed challenges for diversified equity managers as market concentration grows, according to Epoch Investment Partners.

Kera Van Valen, Portfolio Manager of Epoch’s Global Equity Shareholder Yield strategy, said the success seen in global equities has been driven by speculation about the role AI will play in the future.

However, the AI rally has concerned only a small group of “mega-cap tech companies”, with the highly concentrated market leadership leading investors to doubt the benefits of diversification.

“Recent years have seen these firms’ index weights balloon alongside their price multiples and market caps; for example, Microsoft and Apple now make up nearly 10 per cent of the MSCI World Index, which is composed of over 1,500 stocks,” she said.

“High index weights coupled with outsized returns have led to just 7 stocks accounting for over 50 per cent of the MSCI World’s return through the end of the second quarter.

“Indices meant to be representative of the broad market have seen their return profiles skew due to these concentrated position sizes, which presents difficulties for managers like us who emphasise the benefits of diversification in their risk framework and portfolio construction process.

“From an income perspective, it’s difficult since most of the tech companies leading this AI rally are growth oriented and don’t pay dividends.”

Van Valen also said that while the Global Equity Shareholder Yield portfolio has had its share of participation in the AI boom, it is also important to not “lose sight of fundamentals” and to remain cautious of the buzz surrounding AI investments.

“The stocks that have been centre stage during this rally have seen their valuations skyrocket based largely on lofty expectations of future growth; however, there is limited fundamental backing right now. It will be important to watch how earnings unfold over the next several quarters,” she said.

“Companies that will outperform are those with strong market positions, a track record of maintaining and growing cash flow through economic cycles, pricing power and the ability to defend margins. We also look at corporate balance sheets that reflect high liquidity levels to support dividends and share repurchase capability.

“While earnings will likely be pressured by the current macro-economic backdrop, companies that hold these characteristics should prove capable of maintaining earnings growth despite the volatile environment.”