In light of the current narrow leadership we are witnessing in the S&P 500 Index, some private equity (PE) supporters have seized the opportunity to tout the diversification benefits of the asset class. While private equity does indeed provide exposure that naturally does not overlap with the handful of mega-cap US tech stocks dominating public markets today, we do not believe this necessarily warrants a leap into this much more expensive and less liquid asset class.
Putting aside the multiple other asset classes that can serve as diversifiers to public equities, there are a number of public equity indices whose constituents also do not overlap with the S&P 500 that are consistently significantly less concentrated and that have meaningfully different exposures.
In Figure 1, we show the Herfindahl-Hirschman Index, where a higher number indicates greater domination of the market by a smaller number of firms. The index not only confirms the increase in market concentration for the S&P 500 year-to-date, but also shows that 2023 has been business as usual for global developed markets stocks outside of the US (represented by the MSCI EAFE), emerging markets stocks and US small cap stocks (proxied by the Russell 2000).
Figure 1. Herfindahl-Hirschman Index, January 2022 to July 2023
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Source: Man Numeric, Bloomberg data. As at 31 July 2023.
One way to think about diversification is to look at the sector or industry concentration of various indices. Looking through this lens, we find it interesting that some claim PE is a good way to move beyond the narrowness of the US large-cap tech leadership. Figure 2 shows the significantly narrower industry profile of US buyout funds versus the most popular large-cap and small-cap US equity indices.
Note at this point that we have focused this analysis on US companies for a fair comparison with the industry exposure data we have readily available for US buyouts. Given US buyout funds represent the largest segment of PE, we believe this is a fairly representative sample.
Figure 2. Exposure to Three Largest Industry Groups
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Source: Man Numeric, Bloomberg data. Calculated based on GICS level industry groups. Largest industry groups for S&P 500 include: software & services, tech hardware & equipment and media & entertainment. Russell 2000: capital goods (within industrials sector), pharma, biotech, & life sciences and commercial banks. US buyouts: software & services, capital goods (within industrials sector) and health care equipment & services. Data as at 31 July 2023.
Drilling into tech specifically, as shown in Figure 3, the S&P 500’s largest sector is information technology at 28.1%. If one is trying to diversify away from the narrow tech leadership of the S&P 500 Index (acknowledging that not all top market drivers year-to-date are officially classified as information technology), simply moving down in market cap to the Russell 2000 Index isn’t a bad place to start, as information technology is the fourth largest sector in the Russell 2000 Index at 13.5% weight.
As for PE / buyout funds, they are perhaps not the best diversifier on this metric, as information technology forms the largest sector weight within PE funds at 26.2%, according to data compiled by Man Numeric. This figure is similarly substantial as in the S&P 500 Index and almost double the weight in the small-cap Russell 2000 Index.
Figure 3. Index Weight in Information Technology Sector
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Source: Man Numeric, Bloomberg data. As at 31 July 2023.
Software and services, which sits within information technology, is the largest industry group in both the S&P 500 and in buyout funds, with the weights standing at 11.3% and 18.3%, respectively. By contrast, the Russell 2000’s weight in software and services companies is a fraction of buyout funds’ weight at 6%.
This illustrates that there are other ways than PE to achieve genuine diversification from broad-market indices that are also cheaper and more liquid.
(With contributions from John Lidington, Senior Client Portfolio Manager and Nina Gnedin, Portfolio Manager, Man Numeric).
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