The “Magnificent Seven,” equity market concentration, and portfolio strategy

Recent years have proven increasingly challenging for active managers, particularly with increasing concentration at the top end of the U.S. equity market associated with the rise of the Magnificent Seven¹ (Mag 7) group of companies. Portfolio construction is much more difficult when more than 30% of a manager’s risk budget is absorbed by just a handful of stocks. Here, I discuss the distinct challenges associated with such a historically high market concentration and consider an approach to portfolio strategy that can help address them.

How high concentration altered the investing environment

Amid all the numbers and discussions about market narrowness, it is worth remembering two key facts:

• Between 2000 and 2018, if you did not own the five biggest contributors to the Russell 1000 Index, it cost on average 150 to 200 basis points of relative performance annually (see Figure 1). This underperformance is not insignificant—but is still possible to make up elsewhere in the portfolio.
• Between 2019 and 2024, not owning the five largest index names cost more than 500 basis points annually. In four of those years, the cost was over 700 basis points. Such a deficit is much more challenging to make up.

Data for rolling 12‑month returns in 2023 and 2024 show that only 30% of the Russell 1000 universe of stocks outperformed the benchmark.² So, even for a skilled active manager, there is a much higher probability of picking a stock that underperforms relative to the benchmark, simply due to the extreme level of concentration. Suffice it to say, this has been a dramatically different investing environment.

Addressing changes in performance monitoring and comparisons

Another modern investment variable to contend with is the greater propensity to measure performance against the benchmark. Looking back 20 years, investment performance was more typically viewed against a peer group. Today, it is more often about competing against passive strategies and benchmarks.

At the same time, some clients are increasingly focused on owning higher active share³ portfolios. But, in an environment of high index concentration, an active manager’s only recourse to achieve this would necessitate underweighting the mega‑caps—a difficult proposition.

"Good active managers seek to focus on areas of the market where they have an information advantage."

Good active managers seek to focus on areas of the market where they have an information advantage. Among the mega‑cap stocks, vast sources of information are typically widely available, so gaining that information advantage is more challenging. So, when market concentration becomes as extreme as it is today, there needs to be a recognition that active share will decline, unless we consider strategies that can help mitigate the concentration, such as active extension.

An active extension approach to portfolio construction

Given a constraint of investing long only, the challenge is to optimize ways to benefit from the active share that potentially comes from any information advantage or strategic edge an investment process may offer. An active extension approach to portfolio construction is one potentially useful way. It allows more flexibility to further capitalize on the alpha being targeted through stock selection where a particular investment edge has been identified.

An extension strategy⁴ such as 130/30—where the portfolio is invested 130% long and 30% short—seeks to take advantage of information relating to positive and negative views on the many stocks that are outside the 10 largest in the benchmark. In the current environment, everything else has a smaller benchmark weight by virtue of the size of the mega‑caps, so an extension strategy can allow insights across a wider section of the market to be integrated into the portfolio. It can also increase the portfolio’s active share, resulting in a more efficient portfolio. For example, adding an extension approach could allow clients to capitalize further on the alpha generated by an existing strategy where a team of analysts select stocks in their areas of expertise while adhering to risk controls on active position sizes, sector weights, and factor exposures.

"By viewing the Mag 7 companies as a single risk bucket, the weighting can be indexed, leaving enough risk budget to invest elsewhere to target more diversified returns and potential alpha."

From a risk budget perspective, our own approach considers the Mag 7 companies as a distinct group—a separate theme or sector—in a similar way to how we might categorize themes like artificial intelligence or bitcoin. This helps avoid making huge positions in any one theme. By viewing the Mag 7 companies as a single risk bucket, the weighting can be indexed, leaving enough risk budget to invest elsewhere to target more diversified returns and potential alpha.

Mega‑cap fundamentals and mean reversion

There has been much talk about a lack of mean reversion in the fundamentals of the market’s largest stock names. Company fundamentals (such as return on invested capital, revenues, and profit margins) of the Mag 7 are not mean reverting in any way. This is highly unusual in a historical sense. Only as far back as the early days of the rise of utilities and railroads is this kind of non‑mean reversion evident. Then, only after government intervention to break up dominant, monopolistic organizations, did company fundamentals start to mean revert.

So, why isn’t mean reversion evident in the market’s largest stocks currently?

This is an area of analysis I find particularly interesting. Indeed, in 2000, I conducted research into mean reversion trends over the previous 50 years and found that, over the period, company fundamentals ultimately did mean revert.

In 2014, I read a fascinating book called “The Second Machine Age,” by Erik Brynjolfsson. It argued that the competitive advantages of a digital era would be concentrated among ever fewer companies, specifically those with data—and data networks—to fully leverage those advantages. I subsequently conducted a new study in 2016, analyzing country‑ and company‑specific data across several industries. The revenues of the largest five companies in most industries over the period studied increased materially. Concentration had increased in every industry studied as larger companies leveraged technology, spread costs, and benefited from large network effects.

These patterns are identifiable among the Mag 7 today. Indeed, there is a great deal of research showing how the Mag 7 companies are able to capitalize on their access to vast amounts of data. Take Alphabet, for example. Each time a user does a search in Google, it represents more data that the company collects and can utilize. Every search increases their competitive advantage—a self‑fulfilling loop.

A widely held assumption is that today’s dominant tech companies will also be able to capitalize amid the disruptive potential of artificial intelligence (AI). While I am not entirely convinced, in today’s digital era, it is hard to deny that the large tech companies have certain competitive advantages that should help them maintain their non‑mean reverting fundamentals.

Ultimately, there must be a recognition that Mag 7 fundamentals have not mean reverted. Indeed, in recent quarters, the most profitable and highly concentrated group of U.S. companies have only seen margins increase further. This matters because many strategies continue to be heavily value focused. And value strategies, as well as many quantitative strategies, historically have been predicated on mean reversion of fundamentals.

An inflection point for the Mag 7?

What is the outlook for these companies? Although there is a demonstrable absence of mean reversion of fundamentals, we believe that Mag 7 companies are at somewhat of an inflection point.

"Considerable uncertainty remains in terms of identifying the ultimate winners (and losers) to emerge from AI’s disruptive expansion."

For much of the past decade, the companies making up this group were typically asset‑light, secular growers with rising margins. Now, they are more cyclical and asset intensive and face margin headwinds. A key change relates to levels of capital expenditure. Meta, for example, has announced plans to spend USD 65 billion in capex this year, on revenues of USD 185 billion, equating to roughly 30% of sales. Once an asset‑light, noncyclical, secular growth business, Meta is now asset intensive and much more cyclical. While positioned well, this is a major investment where returns are less certain. AI is a technological change likely to be bigger and more powerful in the long term than many think, but some stock prices may reflect the anointing of as‑yet‑unproven winners. Considerable uncertainty remains in terms of identifying the ultimate winners (and losers) to emerge from AI’s disruptive expansion.

Meanwhile, margins for the mega‑cap companies have been historically high—levels that may prove difficult to sustain given higher‑than‑expected tax rates, cost of goods sold, and interest rates. Tax rates may fall incrementally, but substantial cuts seem unlikely. Interest rates remain at levels considerably higher than in recent decades. Arbitrage to support margins—borrowing at close to 0% interest and using the funds to buy back shares—is no longer possible at today’s higher rates.

Last, tariffs represent a further source of uncertainty. While large‑cap tech companies are not as directly affected as some other industries, reciprocal taxes levied by the European Union and Asia seem likely. It draws parallels to the only other time similar, seemingly durable competitive advantages were evident—namely the historical dominance of some companies in the rise of the railroads and utilities—but were ultimately undone by government interventions.

It may be a bold call to suggest the high margins of the Mag 7 companies are no longer sustainable. But I do believe we have reached a peak and we may see a period of margin degradation. As to the full extent, only time will tell.