“Diversification has been a hindrance”: Why that doesn't mean you should abandon it

But what happens to a diversified portfolio when the market becomes increasingly concentrated?

According to J.P. Morgan Asset Management Managing Director of US Equities Fiona Harris, the recent dominance of the AI trade has created a situation where “diversification has really been a hindrance to performance for most active managers”.

“Because of the dominance of the AI trade, being diversified, which most managers are, has not rewarded you. It's done the opposite because the spread between the winners and perceived losers has been very, very wide. It's been a concentrated market,” Harris says.

How you measure the over-reliance on AI and its pipeline could go a few directions. Under a JPMAM analysis, rolling in all of the tech around AI can produce a figure that's something like 50% of the S&P 500.

JPMAM Global Market Strategist Kerry Craig notes that while the chart below outlines how concentrated the S&P 500 is among the top 10 stocks and the sectors they’re in, when you add in all of the other AI-related companies, the number “just keeps going up”.

Is the Australian market diversified?

Notable in the chart above is the complete absence of tech from the top end of the ASX 200. It logically follows that Australian equities are less exposed to the AI trade, at least from the upside.

“There’s not a lot of AI but it’s more broadly diversified, if you want to call it that. But it's obviously financials and resource names,” Craig says.

“One of the weird things, obviously, last month is Australia's seen a bit of quiet outperformance because it hasn't had the AI theme to it.”

AI’s role was in triggering the SaaSpocalypse that wiped out value for software stocks, rather than creating massive returns like in the US and other markets. Spreading exposure across the ASX 200 instead resulted in a massive dispersion in returns

“If you spread your money evenly across the market this year, your returns weren’t so much smoothed – they resembled a barbell: several of your holdings got absolutely smashed, several shot the lights out, and most were mediocre.”

Does this mean diversification is dead?

Tossing diversification in the trash is likely a little hasty, but it’s also hard to tell an investor that has crushed it investing in AI that they’re too exposed.

As Harris puts it: “For a lot of people, betting on semiconductors has rewarded them.”

“What we know about cycles is valuation matters in the end, we know managing risk and being diversified does reward you. So, you still have to have that confidence, that discipline as a manager, rather than trying to chase this market, because these changes can happen very, very quickly.”

The question is where in the cycle we are right now. According to Harris, the answer doesn’t mean investors should be concerned, but it looks closer to being late cycle.

“We will get more and more volatility, big swings on a daily basis or a weekly basis. Remember, with late cycle, it doesn't mean it ends tomorrow. This can go on for a year, two years, three years, but you prepare for those periods of volatility,” she says.

“One of the things that we do know is you can't time these things. The best day to invest is today, the next best day is tomorrow. Whether today or tomorrow or the peak, it doesn't matter because when you're investing, you're investing for the long term, so think about your horizon.”

Growth set to continue

So, if JPMAM expects more volatility, then why are they confident that the market can still go higher? The short answer is growth.

“The US economy is growing. It mightn't be the growth rate that we're used to over time, there isn't a three handle on it or a four handle on the GDP, but it's growing well and enough to support the economy and to support the market,” she says.

“We've got great earnings. The long-term average for earnings in the US is actually about 7% annually, and yet we're seeing a quarter today where, including everything, we're probably 40% plus.”

The earnings outlook, Harris says, is still set to go up over the next two years before normalising towards the long-term average. 

Importantly, there’s nothing causing JPMAM to see a recession on the horizon.

“The market's gotten a little bit cheaper. Now it is expensive, it's 19 times forward earnings, but the multiple hasn't expanded because we've had good returns. We've actually seen the multiple come down because the equity markets have delivered the earnings.”

Ultimately, while Harris is clear that investors should recognise that the current super cycle could continue for a long time, it’s still important to avoid getting caught up in the fear of missing out.

“I think we all recognise cycles all end the same way eventually, and it's that gap between where we are today and where this may happen, and for a lot of people that can be a hard gap to make up when they see the great returns. There's a fear of missing out, but we would say, think about that risk, think about diversification in this part of the cycle.”