Since 2020, increasing levels of concentration in stock market indices have commanded widespread attention. The weight of 10 stocks now accounts for over a third of the S&P 500: an unprecedented level of concentration in the past two decades. This surge has largely benefited capitalization-weighted indices recently. Positive sentiment towards the Information Technology sector, partially fuelled by rapid advancements in Artificial Intelligence (AI), translated into soaring returns for a few mega-capitalization stocks dubbed the Magnificent 7. They include Meta, Alphabet, Nvidia, Tesla, Apple, Microsoft and Amazon.
 

Concentration Concerns

This swift development raises concerns about whether returns fuelled by climbing levels of concentration are sustainable. Historical data shows that market concentration, as measured by the weight of the top 10 stocks in an index, is prone to fluctuations. Periods of elevated concentration have been followed by the reversal of this trend, which means dilution is, at the very least, a possibility.

But is increasing concentration a sign of headwinds? That depends on several factors, including the risk associated with the most heavily weighted stocks. In the S&P 500, the top 10 stocks are massive companies residing in the Information Technology and Communication Services sectors, which tend to experience relatively larger price swings. Additionally, the lack of sector diversification amongst this group implies that there are overlapping factors driving the prices of stocks with the most power to influence index returns. The riskiness of this concentration is evidenced by the climbing levels of risk contribution attributed to the top 10. In an index of around 500 stocks, 10 make up approximately half of the volatility. 

The Role of Low Vol Strategies in Offering Downside Protection

Investors seeking to insulate their portfolios from the riskiness of capitalization-weighted indices may look to low volatility strategies. TDAM's low volatility strategies are designed to be less concentrated than capitalization-weighted indices and they aim to avoid uncompensated risk. These strategies might be beneficial in down markets, as they typically offer enhanced downside protection relative to capitalization-weighted indices. This is important because market losses are asymmetric and compound exponentially; the larger the loss, the higher the gains needed to break even. By avoiding stocks with prices that have higher tendency to vary, low volatility equities focus on winning by not losing.

The selloffs in July, August, and early September this year exemplified how low volatility strategies can potentially shield investors from market whipsaws. Reminiscent of the downturn in 2022, concerns surrounding economic weakness and superfluous investment in AI by private companies mounted into a sizeable market reaction. Stocks with higher volatility, namely the Magnificent 7, bore the brunt of the dip in prices. On the other hand, the TD Q U.S. Low Volatility ETF provided portfolio protection by remaining steady and comparatively unaffected.¹

Risk-aware investors aiming to weather market turmoil and reduce risk at the total asset mix level can potentially look to low volatility solutions for many of the same benefits as capitalization-weighted equities with lower risk and downside protection. These benefits may include comparable returns over the course of a full investment cycle, ease of implementation, and liquidity. Alternatively, investors with a risk budget can use low volatility strategies to redistribute their risk. This is achieved by reallocating the portion of their risk budget freed up by investing in low volatility equities to potentially more aggressive return-seeking assets. Looking forward, investors will likely continue to encounter unforeseen market events accompanied by bouts of volatility, underscoring the importance of preparation.
For more information, check out our earlier article De-Risking Portfolios with Low Volatility Equities.

¹ As of August 31, 2024, the fund has posted a one-year return of 18.17% and a three-year return of 7.91%. It has delivered a return of 10.23% since its inception on May 26, 2020.

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