MLC CIO Dan Farmer’s market concentration warning

A cautionary note has been sounded on passive investing by MLC chief investment officer, Dan Farmer who points to risks, particularly the current US market environment.

In an assessment of current market conditions this week, Farmer also emphasised that market concentration is at its highest in decades, driven by the so-called Magnificent Seven, which account for over half of the S&P 500’s 58% total return from 2023-24 and which carry valuations that require sustained outperformance.

“There’s been a lot of airplay in recent years about the growth of passive investing. We are not anti-passive investing. Far from it,” Farmer said.  “Our approach embraces active, passive, and smart beta strategies, with passive investments included in some of our diversified portfolios for cost-effective, broad market exposure.”

“However, risks should be kept in mind when investing passively, particularly in the current US market environment where passive strategies account for about 54% of exchange-traded funds (ETFs) and mutual funds.

“Passive investors are by definition indifferent to valuations, and have amplified the rise of technology stocks, particularly the Magnificent Seven, as their earnings and multiples have expanded.

“Passive investing can be thought of as a momentum strategy and it does raise the question of what may occur if there is a sharp market drawdown,” Farmer wrote

“The S&P 500’s earnings and valuations are increasingly tied to a small cohort of companies fuelling an AI-driven capital expenditure cycle. This concentration reduces the diversification benefits of passive investments.

In periods of market stress, over-reliance on a handful of dominant firms could undermine portfolio resilience,” he wrote.

Farmer said that as strong proponents of diversification, MLC believe now is an opportune time to explore equity opportunities beyond the US to complement existing exposures.

“Non-US equity markets, including emerging markets, trade at lower valuations than their US counterparts. While a valuation discount alone does not justify investment, it serves as a starting point for deeper analysis,” he wrote.

“Non-US equities, including emerging markets, have been out of fashion for some time and it’s always difficult to pinpoint what may catalyse greater investor interest in markets beyond the United States,” Farmer wrote.

“In earlier decades — specifically the 1970s, 1980s, and 2000s — non-US equities, as represented by MSCI EAFE (Europe, Australasia, and the Far East), delivered stronger average annual earnings growth than the S&P 500. If new market drivers emerge, it’s not unreasonable to expect a changing of equity market leadership.

“For now, active managers, like ourselves, can capitalise on this by identifying quality businesses with under-appreciated earnings potential across global markets. Investors open to diverse risk profiles may find opportunities in a broadening of equity return drivers.”