Has It Begun? Positioning Your Portfolio for a Broadening Out

The first half of 2024 has been marked by megacap performance and heavy concentration within market cap-weighted benchmarks. The Fed Funds rate has remained unchanged for longer than the market previously anticipated as inflation continued its stubborn resistance during the first six months of the year. Accordingly, many investors steered capital into benchmark-driven strategies that are carried by megacap companies. As this phenomenon has played out, we at ARK Invest have emphasised the importance of analysing risk across client portfolios and gearing exposures towards a broadening out. We are now starting to see signs that this rotation may be beginning, though volatility will persist between now and the actual act of the Fed cutting rates. Truly diversified strategies may be an ideal solution for this trade as a new interest regime crystalises whether we enter a “catch-up” or “catch-down” scenario.

Are there signs that the equity market has become overly concentrated?

Various datapoints¹ illustrate that market participants may be over-exposed to a handful of stocks in their portfolios.

• • The S&P 500 Index has the highest concentration in 30 years within its top 10 names, which has contributed to 72% of the total return of the S&P 500 YTD through June 30th.
  • Overlap has tripled between the S&P 500 Index and the Nasdaq 100 Index over the last two decades and the common holdings represent 95% of the weight of the Nasdaq 100 Index as of June 30th.
  • The “Mag 6” contributed to over 50% of total risk in the Nasdaq 100 on a 1- and 2-year basis.
  • The S&P 500 Index outperformed its equal-weighted version in the second quarter by 6.9% as megacaps dominated, which is one of the largest divergences ever (7.1% in first-quarter 2020 was the greatest).
  • Market imbalance in the US is the highest it has been in 100 years, as measured by the largest US company relative to the 75th percentile by Goldman Sachs research. As seen below, this has begun to turn.²

Has the equity market begun to broaden out?

Let’s start by using a single trading day to discuss whether it was an anomaly or if it may be emblematic of a rotation that is beginning to crystalise. July 11th offered a striking example of this broadening out as CPI came in at -0.1% month-over-month signaling that the US Federal Reserve could shift more quickly into dovish policy.

• • The Nasdaq composite – held up by cash-rich megacaps – lost roughly -2.0% on the day, while the Russell 2000 – representing small cap stocks – gained 3.6%; the largest single day differential in the last 30 years.³
  • Another clear example: stocks associated with multiomic technologies, which tend to be long duration in nature based on the earlier-stage profile of underlying companies – and as represented by ARK’s Genomic Revolution strategy (ARKG), were up 5.6% on the day.⁴
  • Since the 11th this trend has continued with pure-play disruptive innovation, as represented by ARKK , returning 5.9% relative to the Nasdaq 100 Index’s loss of -4.2%.

Focusing on a longer period to provide deeper context, we can see the major shift in performance for diversified strategies starting in July as evidenced by the path of performance of our strategies since April 2024.

Source: ARK Investment Management LLC, 2024 with data pulled through Bloomberg. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security. Past performance is not indicative of future results.⁵

Will more performance dispersion follow? The Mag 6 may be highly sensitive to external risks in light of its first-half performance. For example, we observed the harsh market reaction to presidential nominee Donald Trump’s statements about the funding of Taiwan’s defense and tariffs on Chinese exports on July 17th.

NVDA – reliant on its partners in Taiwan – traded down 6.6% on the day, shedding close to $200 bn in market cap (roughly the market cap of Roku, Coinbase, Block, Palantir, and Crispr Therapeutics combined), bringing its performance from July 11th through July 17th to -12.5%.⁶

Indeed, we believe that the broadening out is taking shape and that diversified investment solutions will help client portfolios achieve enhanced risk-adjusted returns in various market scenarios.

Do ARK’s active ETFs offer a solution for the broadening out trade?

As interest rates potentially normalise – which will continue to be the most material driver of market volatility and performance – we believe that ARK’s innovative strategies offer a solution for this broadening-out trade due to unique characteristics outlined below⁷:

• • Active Share: Truly differentiated strategies, as expressed by high active share relative to broad benchmarks, should be natural beneficiaries of the market’s broadening out. High active share can stem from first-principles, top-down research and/or benchmark-agnostic, bottom-up stock selection, or through thoughtful index construction that avoids plain vanilla market-cap weighing schemes to instead focus on theme purity.
  • Rate Sensitivity: Pure-play disruptive innovation is inherently high duration given the profile of underlying companies. As the expectation, and eventual reality, of rate cuts materialises, the performance of these strategies should experience upside volatility.
  • Valuations: Crucially, many benchmark-agnostic strategies are deeply discounted based on concentration and interest rate sensitivity, which further showcases the ability for them to act as a coiled spring in a declining interest rate regime.
  • Technological Tailwinds: Importantly, the stocks associated with disruptive innovation are benefiting from technological tailwinds associated with disruptive innovation, with AI as the central fuse behind convergent growth. While value and/or small cap stocks may also experience a performance catch-up or catch-down, we believe that disruptive companies will benefit more substantially in a broadening out environment due to their exponential growth characteristics .
  • Artificial Intelligence (AI) is the Central Fuse: While a rotation away from megacap names could negatively impact check-the-box names associated with the AI revolution, such as Nvidia, the tailwinds driving artificial intelligence remain strong and evaluating downstream effects of AI adoption remains nuanced. Importantly, many off-benchmark names, from AI platform plays to convergent applications, may represent the next wave of AI potential, and these types of should benefit from both momentum in AI and the broadening out. ARK’s AI & Robotics ETF seeks to position itself for this opportunity set.

Where do we go from here?

Importantly, a broadening out trade can be accretive to client portfolios in more than one market scenario.

• • “Catch-Up” Scenario: In this risk-on scenario, the positive momentum of a more diversified set of stocks will lead to a narrowing of the performance gap to megacap stocks in an upside market.
  • “Catch-Down” Scenario: On the other hand, investors may be weary of the potential for downside pressure after many market-cap weighted benchmarks recently hit all-time highs. A market downturn could be triggered by weakness in the Mag 6, potentially due to the interconnected nature of their sales and earnings and/or a falling rate scenario that no longer rewards companies with extensive cash balances, leading to a narrowing of the gap as a diversified set of stocks loses less than the megacap names.

Of course, there is a potential that forthcoming data points, whether related to inflation or employment, may decrease the probability of the Fed cutting rates sooner, which would increase downside risk for this trade. That said, the economic data, trend in performance, expected path of Fed dots, deeply discounted valuations, and technological tailwinds give us conviction that the broadening-out trade has increasingly become a nearer-term, if not current, market event.