Building a balanced portfolio? Watch out for these hidden risks

Concentration risk has become one of the most popular conversations in investing in recent years. The dominance of US markets, and within that of a handful of large technology companies, has created concern that investors may end up with a lack of diversification with their investments.

But efforts to reduce concentration can lead portfolios into more treacherous waters than those they left.

Managing risk has always been of real importance to the AJ Bell Investments team. Each of our funds has a specific band of volatility that it must fall within that creates a natural balance between risk management and growth. But when a single risk becomes the overarching headline, it can be easy to forget about other potential investment hazards that are just as relevant.

Can small cap companies help?

Some investors have started to look towards small-cap companies to bring more diversity to their portfolio. These markets do tend to have exposure to a different group of themes, but small cap companies are, in general, higher risk than larger companies. They often have fewer resources, less robust balance sheets, and sometimes shorter track records than the bigger players.

So, while they might provide something different, it isn’t necessarily better. For example, the IA North America sector, which includes funds invested in this part of the market, has returned 232% in the past 10 years in terms of Sterling. The IA North American Smaller Companies sector has returned 172.3% in the same time frame. While the two generally move in tandem, the smaller companies sector tends to fall a bit more dramatically in times of market drops.

The same pattern of quite dramatic falls for investments focused on smaller companies occurs in the UK. Namely, the period of high inflation following Covid-19 proved to be a struggle for UK smaller companies, causing a sustained fall.

The tendency for smaller companies to be less stable means they are not a big part of the strategy for the AJ Bell team. We often view the risks they present as outweighing any diversification benefits they offer.

Moving out of the US

The US is home to many of the largest names in tech, which means that investing heavily in the US can create a concentration risk. As investors look to diversify away from that focus, we’ve seen the rise of alternative fund options which look to exclude the US and increased flows to other regions, such as the UK and Europe.

This can be helpful to some degree. We have long held an overweight position in the UK because we believed the market was undervalued. The past two years of strong performance has proven that to be true but has also closed the valuation gap we saw before.

While there are quality companies in both the UK and Europe, we typically find the companies with the most growth potential sit in the US. For example, US-listed Eli Lilly has seen its share price increase by 375% in the past five years to 26 August, while UK-listed AstraZeneca’s share price is up by just 44% over the same timeframe.

Looking to sectors

Broadly speaking we see plenty of strength across US businesses and still see a lot of appeal in the region. To balance this with limiting the concentration of US tech stocks in the portfolio, we’ve opted to take a sector-by-sector approach.

At the start of this year, we increased our exposure to the US market. Instead of simply putting more funds into the main S&P 500 market, we identified specific sector allocations including utilities, energy and healthcare.

We believe that these areas of the market have much more protection from shifts in sentiment around AI: people will always need water, electricity and medical treatment. In addition, while these markets haven’t felt the boost in investment that technology has, they still stand to benefit in the longer term.

We are already seeing a large uptick in the water and electricity used to run data centres.

By taking the approach of investing through sectors, we can target the parts of the market we don’t see as overpriced while still taking advantage of the strong business prospects and growth of the US.

No investment can avoid risk entirely, and each of these sectors come with their own challenges as well. For example, we’ve already seen big movements in energy markets this year as the situation shifts around the US and Iran war. The good thing is that they do move more independently from each other, which gives investors the much needed variety when markets are more volatile.