Been to the cinema recently?
If you have, you may have seen the recent blockbuster Oppenheimer, in which director Christopher Nolan tells the story of how Robert J. Oppenheimer gradually comes to appreciate the enormity of his creation, and the profound impact it will have on the world.
I believe that investors in today’s markets need to travel down a similar (but thankfully less destructive) path of realisation.
The good news is that this realisation, unlike Oppenheimer’s, could help investors avoid significant damage to their portfolios.
The bad news is that the adjustments required are likely to be an uncomfortable step outside of the well-trodden, comfort zones investors have been used to investing in recently.
Context
Over the last decade, markets have been dominated by a few strong trends.
These trends have been very positive for shares in high growth sectors (such as technology), mega cap companies and the US market more broadly.
Because most indices are market-cap weighted, periods of strong trending like this increase concentration: winners keep winning so indices and portfolios become more concentrated in those winners.
The effect of this is particularly pronounced when the trending is strong in the larger companies, as it has been.
This, too, shall pass.
Any long-term study of markets will show that markets tend to move in long-term cycles, and through different regimes. The strong trending in place recently has left many portfolios exposed to significant risk of loss if there is a shift in the market regime. The return of inflation is a potential trigger.
To try and get a sense of how unbalanced portfolios may be, we looked at the largest UK based funds in the Investments Association’s 40-85 per cent equity fund sector.
This is a large and widely used category of funds that includes the classic 60/40 benchmark. I took the largest passive fund as a proxy for the benchmark, alongside the four largest active funds:
As of August 31 2023, these funds held more than £28bn of UK savers’ money so this accounts for a large chunk of UK portfolios.
Using Morningstar’s data, we then looked at the correlations between these largest funds over the last 10 years, in other words how closely the largest funds move in line with each other. A correlation of one, or 100 per cent, means that two funds or investments move in lockstep.
Each of the five largest funds has a correlation with the other members of the group ranging from 0.82-0.95.
On average the correlations are a lofty 89 per cent, and this picture does not improve if you include the next five largest funds either.
How has this happened?
When markets trend strongly for a number of years, portfolios can end up converging. Underperforming contrarian managers lose clients, while more flexible managers adapt to the market environment.
