Diversifying away from the Magnificent Seven

The investment world has a new buzzword, the ‘Magnificent Seven’, which refers to seven technology-related US businesses whose fast growth has been powering market returns: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.

Fuelled by the artificial intelligence (AI) boom, the group have shot up in value in recent years, and particularly the last 18 months, giving them a total market value of around £12.8 trillion at the end of June¹.

However, mixed earnings results and concerns over political and regulatory risks have seen their share prices stumble over the summer months. Tesla has even lost its place as one of the seven largest US companies, albeit it was another tech-related company, Broadcom, that overtook it.

With all the excitement, investors might be asking themselves if they should include the Magnificent Seven in their portfolios. However, there’s a very good chance that they already do.

The obvious places to look for them are in technology funds, or growth-focused US or global funds. But even investors that don’t own these, might find they’re exposed to some of the Seven anyway, because their sheer size makes them hard to avoid.

After all, the Magnificent Seven make up around 30%² of the US stock market (MSCI USA) and hence would comprise a similar share of any US tracker fund. Those investing internationally might also have substantial exposure to these companies as they make up almost 20%² of the global market as measured by the MSCI All Countries World index.

A key principle of investing is diversification, often referred to as not having all your eggs in one basket. Not having all (or a large proportion) of your eggs in seven baskets might not be sensible either.

That’s not to say that any of these companies are likely to disappear any time soon. However, their recent market wobbles have shown that they are not invincible. Once mighty tech companies like IBM, Intel and Cisco are now dwarfed by the Magnificent Seven, and they too could one day be surpassed.

So how can those concerned about their exposure to the Magnificent Seven reduce their exposure?

Be wary of tracker funds. Tracker funds can play a valuable role in portfolios, but holding every stock in an index doesn’t always provide the diversification you would expect. Holders of popular US tracker funds could find themselves with 30% of their portfolios in the Magnificent Seven and a further chunk in other technology-related names.

Equally weighted exchange-traded funds (ETFs) are a possible way around this problem – by splitting the portfolio evenly across all companies in the index they have less of a bias to larger companies than standard ETFs that weight holdings by company size.

Consider value-focused US strategies. The Magnificent Seven – and US-technology stocks more generally – look expensive on many valuation metrics. As a result, US value funds – those focused on stocks that are cheaper than the market – tend to have lower exposure to technology than the market, focusing instead on other sectors.

As the chart below shows the MSCI USA Value index – a popular benchmark for value managers – has just 12.3% in the technology sector compared to 31.3% for the MSCI USA. Instead, the value index has higher weights in a range of sectors like financials, health care and industrials, potentially offering valuable diversification. While value-focused strategies could offer less exposure to technology stocks, as with all investments, they still carry risks and your investments could go down in value as well as up.

Consider smaller US companies. Many investors are wary of smaller companies, and with good reason – in many ways they are riskier than their larger counterparts, as they can be less liquid and more volatile.

However, they can offer exposure to other sectors, which might offer different growth drivers, as the chart below shows. Most notably, they have far less exposure to information technology and communication services. Instead, they have higher weights in industrials, financials and consumer discretionary. As a result, US smaller companies funds could be a useful way to diversify away from their tech-heavy large-cap counterparts.

Don’t forget the rest of the world. The US represents around 65% of the global stock market, as measured by the MSCI All Countries World index². Given the strong performance of the US market in recent years, investors could be forgiven for thinking that it’s all that matters. However, focusing just on the US could mean losing out on opportunities elsewhere.

Funds investing in Europe, Asia or emerging markets provide geographic diversification away from the US, but also offer exposure to a greater range of industries than US funds, which are often dominated by tech. If you don’t want to lose exposure to the sector, they still have their own technology companies like Korea’s Samsung or Germany’s SAP, sometimes at lower valuations than their US rivals.

Many investors are familiar with the importance of diversification, of not investing too much in a small number of assets. However sometimes market movements make that decision on our behalf, increasing portfolio weightings in areas like the US, AI-related stocks, or the Magnificent Seven.

The dominance of the Magnificent Seven in the technology world makes it unwise to bet against them, but betting too heavily on them might not be sensible either. In today’s markets, making a portfolio more resilient might mean making it less ‘Magnificent’.

1. Morningstar; July 2024
2. MSCI; July 2024

MSCI disclaimer: Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.