The Exposure Risk of Global Investment Funds – October 2024

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Passive investment funds, popular with retail investors for their value and ease of access, aim to replicate the performance of stocks in a given market or sector. Roughly a quarter of these funds profess to offer investors global exposure, rather than focusing on any one market. However, upon closer inspection, these “global” funds are often disproportionately weighted towards the US market, especially the technology sector. This is a result of both the outperformance of the sector in recent years, as well as the significant market capitalisation of US stocks compared to their peers.

One of the main reasons why US stocks account for a larger portion of global funds is down to market capitalisation. Simply put, the US stock market, led by giants such as Apple, Microsoft, and Nvidia, represent a significant portion of global stock market value. According to data from various global index providers, US stocks alone account for over 55% of the total value of stocks globally. This massive weighting is mirrored in passive funds to offer investors a true representation of global equity exposure.

Within the US market, the technology sector is particularly dominant. The so called “Magnificent Seven” stocks in particular have grown at extraordinary rates due to their ability to innovate and capitalise on emerging trends. These firms have been at the forefront of technological developments in recent years, such as artificial intelligence (AI), the internet of things, and cloud computing. For example, Microsoft’s Azure platform and Amazon’s AWS have become central players in the rapidly expanding cloud services market. Similarly, AI advancements are opening new opportunities in industries ranging from healthcare to logistics, positioning tech companies for long-term growth. A host of semiconductor manufacturers, most notably, Nvidia, have been central in facilitating this, with their share prices having been generously rewarded as a result.

This innovation over the last decade has helped US tech companies generate revenue growth and profitability, and, with that, some of the strongest returns in the market, whilst further whetting investor appetite for future tech trends. These companies have often benefited from their first-mover advantage, access to large pools of capital, and a vast consumer base, solidifying their dominance in global indices.

Whilst the recent track record of US tech stocks may seem appealing, concentration is something investors should consider. By investing in a global fund heavily skewed towards US tech, investors assume more sector risk and are therefore exposed to greater levels of volatility if an event impacting the tech space were to materialise. For example, in late July both President Biden and Donald Trump made remarks regarding the need for the US to curb sales of AI-enabling semiconductors to China. This led to a significant selloff in chipmakers before spilling over into other areas of the tech sector. With a portfolio heavily concentrated in one sector, it is difficult to mitigate poor performance with strong performance elsewhere.

As well as the risk of trade disputes, investors should also consider regulatory risk, economic risk and currency risk when allocating capital. One of the main regulatory risks to the tech sector is antitrust, which refers to laws and regulations designed to promote competition and prevent monopolistic practices. Whilst intended to increase competition and benefit consumers, antitrust can be a thorn in the side of big tech. For example, The US Department of Justice (DOJ) is currently leading efforts to break up Alphabet, Google’s parent company. In 2020, the DOJ filed an antitrust lawsuit, accusing the company of using its market dominance in search and online advertising to stifle competition. The lawsuit focuses on Google’s monopolistic practices, including exclusive deals with phone manufacturers and browser developers to maintain its dominance. The DOJ aims to break up parts of Google’s business or impose restrictions that could limit its control over key markets.

Antitrust also closely scrutinises mergers and acquisitions (M&A), something which is rife in the tech sector, leading to fewer takeovers of smaller companies by their larger peers. M&A activity often drives up the value of target companies by allowing them to tap into the larger resources, customer bases, and capital from the acquiring firm, whilst benefitting the acquirer by granting it access to the innovative capabilities and intellectual property of the target firm. However, increased regulatory oversight can stifle the competitive ecosystem that M&A activity can help to create, constraining growth and ultimately returns for investors.

Inflation, and resulting monetary policy to deal with it, also poses a risk to tech stocks. Growth stocks such as tech rely on the expectation of high future earnings growth. When central banks raise interest rates to tame inflation, the discount rate used to calculate the present value of these future earnings increases, making the future cash flows worth less in today’s terms. As a result, the share prices of tech companies tend to drop, as their high future growth prospects become less attractive under higher interest rates. This in turn leads to increased volatility as investors reassess the value of these stocks.

A recent example is the period following the COVID-19 pandemic, when inflation surged and central banks, including the US Federal Reserve, were forced to aggressively raise rates. This had a pronounced impact on tech stocks, which saw steep declines due to the sudden rise in discount rates. Major tech-heavy indices, like the Nasdaq 100, experienced significant downturns in 2022 as a result.

Additionally, non-USD investors should be aware of foreign exchange risk when investing in global funds heavily skewed towards the US, because returns could be impacted if exchange rates move significantly during the investment period. For example, in Q3 of 2024, the S&P 500 Index returned 5.5%. However, because the USD fell 4.7% against the pound, the majority of gains made by UK investors in US stocks were wiped out. Therefore, exchange rate fluctuations can heavily influence the final returns on foreign investments.

A key consideration for investors should always be diversification. If already invested in the US market, either via individual stocks or funds, investors should be aware that buying a global fund will dial up US exposure further, resulting in an overweight allocation. Whilst that could be tempting due to the market’s strong returns, its dominance presents risks, including sector concentration and regulatory challenges. Ensuring that investments are properly diversified across different regions and sectors is critical for long-term stability. For example, European stocks may offer a heavier weighting towards manufacturing, healthcare and consumer goods, whilst emerging economies offer exposure to rapidly growing markets and developing consumer preferences. Investors should always properly assess their options to ensure that they are getting the diversification required.

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