Smart diversification: European equities’ role as portfolio de-concentrators

With global equities more than ever dominated by US stocks and US equities themselves increasingly skewed towards the tech sector, Niall Gallagher analyses the role European equities could play as portfolio diversifiers.

24 October 2024

It is no secret that US stocks have been the main drivers of global equities’ robust recent returns. Such has been the dominance of the US market, global equity portfolios have become increasingly biased towards US stocks, with US companies now accounting for a staggering 71.8%¹ of the MSCI World Index (as at 30 September 2024). To put things in perspective, at the country level, Japanese and UK companies have the next biggest weightings, amounting to a mere 5.6%¹ and 3.7%¹ respectively of the world index.

Of course, the tech-heavy Magnificent Seven – Nvidia, Amazon, Microsoft, Meta, Alphabet, Apple and Tesla – have been core to US equities’ outperformance, helped by AI-related excitement and demand for megacaps.

But the consequences of this outperformance – and just how skewed global indices have become towards US stocks – could come as a surprise to many investors looking to maintain diversified global portfolios, particularly to those relying on a passive investment approach.

The US equity market is now uniquely concentrated in historical terms

The S&P 500 Index may still have approximately 500 constituents, but, in practice, concentration risk for index investors has never been higher. In market capitalisation terms, the top 10 constituents – that is the Magnificent Seven², plus chipmaker Broadcom, Warren Buffett’s investment conglomerate Berkshire Hathaway and pharma Eli Lilly – now amount to 34.6%³ of the entire S&P 500 Index.

US equity market is very concentrated

Concentration risk is at all-time highs

The top 10 largest US stocks as a percentage of total market capitalisation

Such has been the dominance of the tech-centred megacaps, as the below table demonstrates, passive index-led investing offers much less by way of stock-level diversification than many might expect from the US market.

Plainly, when times are good for the stocks with the most dominant weightings, no index-based investor is going to complain about their gains. However, investors should at least be aware of the stock-level concentration risk in holding the US benchmark index, then decide whether they are comfortable with this level of concentration.

On the face of it, any investor uneasy about the present concentration risk in US equities might consider diversifying into global equities instead. However, closer inspection suggests that a global index-based approach could offer only limited relief.

Global equity indexes are now little more than US-lite

Concentration risk is at all-time highs: top 10 largest stocks as a percentage of total market capitalisation

Such has been the dominance of a limited number of US stocks that even global equity indices now include outsized allocations to the same US megacaps that dominate the major US indices. Nvidia, for example, has 6.8%⁴ weighting in the S&P 500 Index and a still-hefty 4.3%⁵ weighting in the MSCI World Index.

And of the top 25 constituents of the ‘global’ MSCI World Index, 23 are US-listed – only Europe’s Novo Nordisk and ASML appear in this list, and only then in 21st and 24th place respectively. So much for diversification out of the US and into global equities – the global index is hardly offering the kind of diversification away from US tech-sector megacaps that some investors might be expecting.

Europe’s role as a US – and US-lite – diversifier

Investors aiming to improve diversification away from the heavily concentrated US market, and concerned that global indices may be more biased to the US than they would prefer, might do well to consider a role for European equities as a diversifier. In our view, a combination of attractive valuations, a broad range of leading companies with strong global franchises, as well as a lower stock concentration risk at the index-level and improved diversification at the sector level, highlight the appeal of European stocks.

Europe’s indices are less concentrated in megacaps

In the US S&P 500, the three biggest index constituents – Apple, Microsoft and Nvidia – have weightings of 7.1%, 6.8% and 6.3%⁶ respectively, and, as discussed previously, the top 10 index constituents amount to almost 35%⁷ of the entire S&P 500 Index. In contrast, European equities exhibit much lower levels of concentration; the top 10 constituents of the MSCI Europe Index have a combined weighting of just 21.7%⁸, while Novo Nordisk, ASML and Nestlé, the three biggest constituents, have weightings of 3.3%, 2.9% and 2.3%⁸ respectively. So the MSCI Europe Index is much less concentrated in megacaps than its US counterpart.

Europe offers greater diversification at the sector level

The US information technology (IT) sector on its own amounts to 31.7%⁹ of the S&P 500 Index. Add in the communications sector, which includes tech-focused names like Meta and Alphabet, and the concentration amounts to 40.6%⁹ across just these two sectors of the 11 of which the index is comprised.

Sector exposure breakdown: Concentrated US (left) versus more broad-based Europe (right)

The tech-sector tilt of the US Magnificent Seven stands in contrast to the greater sector diversification of Europe’s so-called ‘GRANOLAs’ – GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, Sanofi and SAP, which span sectors such as healthcare, consumer staples, consumer discretionary and IT. Taken together, the healthcare (16.1%), consumer staples (10.8%), consumer discretionary (9.8%) and IT (7.5%)⁹ sectors amount to a combined weighting of 44.2% in the MSCI Europe Index. In the US, only a single sector, IT, at 31.7%¹⁰, has a weighting of over 13%, whereas Europe’s financials, industrials and healthcare top that threshold, emphasising Europe’s greater diversification at the sector level.

Europe’s diversification extends to where corporates generate their earnings

More than ever before, European companies are beneficiaries of global economic growth. In fact, today Europe-listed companies generate approximately 60%¹¹ of their earnings from outside Europe, with the US, Canada and Asia ex-Japan the main drivers over the last 15 or so years.

European companies are exposed to global growth

Significant revenue and earnings gains from strong USD

European companies are now less dependent on the performance of their domestic economies, and now have truly global earnings exposure. Anyone needing convincing of this might care to consider why Germany’s DAX is setting all-time highs at a time when the German economy is performing particularly poorly. The reason is simple - for a company like SAP, the German market really does not matter that much. What truly matters is how SAP’s global software business is performing. And, as the global businesses behind many German-based corporates are generating attractive earnings, the DAX index is performing well.

One benefit of European stocks’ increasingly global footprint is that many of the European companies we invest in are real beneficiaries of major initiatives such as the US Inflation Reduction Act. For example, European businesses selling compressors into the US market are gaining sales in carbon capture and hydrogen generation applications. By investing in what we term Europe’s global winners, investors can potentially capitalise on major earnings drivers across international markets, with the US especially significant for many of Europe’s leading businesses.

Why a style-flexible approach makes sense in Europe

Despite the extreme stock-level concentration of major US indices at present, the US stock universe remains both broad and deep, so dividing the US market up into growth, core and value, and large, mid and small caps can make sense. Despite a proliferation of high-profile companies operating on a global scale and a total market capitalisation of over USD 15 trillion¹², European stock markets cannot match the vast scale of the US market, hence it is more difficult to produce a pure value or pure growth portfolio in Europe. Therefore, in our view a style-rigid approach does not work to the same extent in Europe. So, given the nature of European stock markets, a style-agnostic approach is more appropriate, especially for those looking to capture the key thematic trends that we believe are set to dominate what we term the ‘new investment era’.

To capitalise on themes such as the normalisation of interest rates, decarbonisation and the capex super cycle, and the rise of the Asian middle class, we believe investors need to look beyond traditional rigid ‘growth versus value’ approaches and instead be much more style flexible. If we are looking to build portfolios aiming to capitalise on the scale of diversified opportunities in Europe’s global winners, then we can best play these themes by investing in our favoured stocks across sectors such as banks, energy, industrial cyclicals, premium consumer discretionary/luxury and technology. And we believe that the diversified nature of the European stock universe provides active managers like us scope to build portfolios with the level of stock-specific risk we seek in line with our key investment themes as we aim to capitalise on Europe’s long-term global success stories.

We believe the lower stock-level concentration, greater sector-level diversification, an increasingly global earnings footprint and attractive valuations make European equities an interesting proposition for investors.

At the very least, in our view, European equities represent highly attractive diversifiers for those uncomfortable with their existing exposure to the highly concentrated US market, and the surprisingly US-biased global market indices.

Niall Gallagher manages European and Continental European equity strategies at GAM Investments