Is it time for your portfolio to invest beyond the Magnificent Seven?

The US Equity market has had a great run over recent years. The S&P 500 Index, which tracks the performance of the 500 largest companies listed in the US, has returned 50% over a two-year period.

A lot of this stellar performance came from a handful of large technology companies like Apple, Microsoft, Amazon, and Nvidia.

Part of the reason these few mega-cap companies performed so well was their ability to benefit from higher interest rates.

Back in 2020/21 when interest rates hit near zero levels these companies issued long-term debt taking advantage of low borrowing costs. As interest rates rose, these companies then earned higher interest on their cash balances - which are some of the largest in the world.

The other reason for their growth was increased profits from the AI boom.

Nvidia is the best example with the chip manufacturing business earnings growing by 288% last year. Amazon, Microsoft, and Alphabet all saw cloud revenue re-accelerate as AI models are housed on the cloud, whilst Meta (formerly Facebook) improved add revenue using AI applications.

Up until recently, the rest of the market outside of these few companies had struggled.

Excluding the seven large technology companies coined the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) earnings growth and price performance for the S&P 500 would have been almost 0% from the end of 2022 to mid-2024.

These companies, which typically have shorter-dated borrowing commitments, felt the brunt of higher interest rates as well as higher input costs from inflation and a dampening consumer as the Fed aimed to slow the economy.

However, with the US Federal Reserve beginning a rate-cutting cycle the tides may be turning for the other 493 in the S&P500.

Since the soft June CPI print in the US which created a strong signal to investors that the Fed would begin cutting rates the 493 has outperformed the Magnificent Seven by about 5%

Next year, earnings for 'the 493' are expected to grow at 13% up from just 3% over the past 12 months. Meanwhile, earnings growth expectations for the Magnificent Seven are still positive at 18% but this is coming down from 26%.

With a lot of investors underweight the 493 now may be the time to consider how to get greater exposure to them.

Equal weight approach to US equities

By far the most popular form of passive investment benchmarks are those where constituent stocks are weighted according to their size (market capitalisation). Some of the most well-known indices, such as the S&P 500 and the S&P/ASX 200, are examples of such a weighting methodology.

The rise of smart beta investing provided an alternative approach to passive investing. Smart beta refers to passive, rules-based strategies that seek to weight indices by something other than market capitalisation.

One simple alternative is an equal weight index. In an equal weight index each company receives the same weight on each rebalance.

For example, in the S&P 500 Equal Weight Index each company within the S&P 500 is re-weighted to 0.2%.

Whilst not targeting any specific investment factor, indices based on equal weight have produced long-term outperformance relative to their market cap-weighted equivalents. In the case of the S&P 500 Indices, the outperformance over the past 30 years has been 0.48% p.a.

Such an approach can also provide investors with much greater diversification across a larger number of stocks. For instance, at the moment the bottom 400 stocks in the S&P 500 have a weight of just 30% compared to 80% in the equal weighted version.

Considering the recent changes in market dynamics and the potential for equity market strength to broaden out across more companies, now may be an appropriate time for investors to consider if their portfolios have become concentrated in large cap technology names.

Historically the equal weighted S&P 500 Index has experienced its greatest periods of relative outperformance when concentration in the market capitalisation weighted S&P500 Index is high and subsiding.

For example, from August 2020 to December 2022 when top 5 concentration in the S&P 500 fell by 5% the S&P 500 Equal Weight Index outperformed the S&P 500 Index by 16%.

Australian investors can get access to these strategies via equal weight ETFs on the ASX.

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