It is hardly revelatory to write that a handful of tech stocks drove the lion’s share of the US stock market’s gains over 2023.
Indeed, Asset Allocator has written about the worries many investors have about concentration risk within their portfolios.
So with this in mind, Asset Allocator thought it worthwhile to see to what extent fund pickers are using small and mid-cap US equity funds to diversify away from the heavily-stacked tech sector.
Looking at our proprietary database, we found just under half of the allocators we cover have small-cap holdings of any size at all, meaning the majority prefers to rely exclusively on large and mega-cap US strategies that feature the biggest names.
Within those DFMs who do use US small and mid-caps, the average weighting to these is 12 per cent of total US holdings, and, more broadly, small and mid-cap US funds comprise an average of 1.75 per cent of DFMs' total exposure.
After the number-crunching, we took a well-deserved break before speaking to two allocators about how they find value further down the market cap scale.
Exposure broken down
Of the 25 allocators we looked at, 14 have some form of exposure to US small caps with the most popular vehicle for this being Premier Miton US Opportunities (which isn't strictly speaking a small cap fund but it steers well-clear of large caps anyway).
The folks at Downing have one of the largest exposures to US small caps - indeed all their US holdings are small cap funds.
They told us they get most of their exposure to large caps through global equity funds since these tend to have a large-cap bias.
“So when we are looking at regional funds like in the US, we gravitate towards small and mid-cap managers as this is where it pays to have specialist expertise,” Simon Evan-Cook said.
“It means our US funds are highly unlikely to have exposure to the so-called 'Magnificent Seven', which has hurt short-term performance, but we firmly believe they will generate strong long-term returns.
"On those US tech stocks, while we don’t make predictions, we can see some large risks developing in many passive funds given how massive they are within indices and how much they have driven global markets over recent times."
Evan-Cook said his 100 per cent equity portfolio had just 2 per cent in the 'Magnificent Seven' compared to 17 per cent for a global tracker.
The US funds which Evan-Cook holds include First Eagle US Small Cap Opportunity, Spyglass US Growth and Snyder US All Cap Equity.
Conceptual approach
Jason Day of Abrdn gave us his thoughts on the Vanguard US Equity Index, his preferred choice of passive vehicle that captures more than 3,600 American companies within its vast remit, offering a mix of shares in companies big and small.
His portfolio has no exposure to exclusively small-cap US funds.
Day said: “We approach this conceptually as ‘smart beta’ as the fund tracks the far more broadly constructed S&P Total Market Index and as such contains mega caps, large caps, mid-caps, small and micro caps in contrast to the ‘blue chip’ S&P 500.
"The fund beta is marginally higher than the S&P 500, which is expected given the tail of mid- and small-caps within the index.
"Incidentally, small and mid-caps would have traditionally been the areas that active managers would have used to generate returns above the mainstream index, but over recent years very few managers have been able to consistently outperform the S&P 500 which is why we like the construct of this index fund.”
He added that small- and mid-caps were more exposed to a US recession and would be expected to underperform, though would stand to gain most from the Fed’s potential interest rate cuts which are predicted for this year.
Vanguard US Equity Index is used by just four allocators in total and is much less popular than the Fidelity US Index (an S&P 500 tracker) held by 11 different DFMs and in far greater proportions.
Overall, average US equity allocation among our DFMs is 15 per cent and has remained thereabouts since the inception of our records.
The predicted US recession that is yet to happen may be the deciding factor for our allocators as 2024 gets underway.
joseph.wilkins@ft.com
