Page 472 - DCAC February 2024 Files

challenging for managers and strategies that favor greater breadth.
When considering the Magnificent Seven, there is significant factor
exposure to quality and momentum and negative exposure to size
(small companies) and value (inexpensive companies), which has a big
impact on the overall index.

Influence of AI on Future Returns
Artificial intelligence hype hit an all-time high in 2023. A lot of this can
be attributed to the belief that it is more than just a new market and,
rather, is a foundational technology by which other markets will be
created. Investors are expecting that the productivity increase realized
from AI could drive macroeconomic growth for years to come.
We believe that AI will likely have a sustained, significant impact on
market returns over the next decade and beyond as economic growth is
primarily driven by three main factors: capital, labor, and technological
meaning that the larger a stock’s size, the larger their share of the advancement. Many countries and geographic regions around the
overall index. As these companies become a larger portion of the global globe are currently experiencing decreased labor and capital growth.
stock market, they have a bigger impact on overall returns, which could We believe a growing portion of future economic growth will come
lead to greater portfolio risk. The concentration of market returns in from technological advancement, and specifically artificial intelligence.
just a few mega-cap stocks, dominated by the information technology According to a recent study by McKinsey & Company, generative AI has
and communication services sectors, could lead to heightened volatility, the potential to deliver significant economic benefits, adding between
1
reduced diversification, and increased systematic risk for investors. $2.6 and $4.4 trillion in global corporate profits annually .
Most of these companies are more alike than different and are, in various At a micro level, we are approaching AI-based investments with cautious
ways, exposed to the same secular trends. Consider artificial intelligence, optimism, as it often takes time to see meaningful adoption when it comes
cloud technology, augmented/virtual reality, and autonomous vehicles to disruptive technology. This is likely a major competitive advantage for
as examples. This overlap increases the systematic risk of owning these early adopters, primarily the Magnificent Seven, who have spent billions
stocks within an index or portfolio, as these companies generate a large of dollars building out their technology and have expansive customer
portion of their revenues and future expected returns from similar risk bases to tap. While there will be several new entrants and disruptors,
factors, diminishing diversification and its related benefits. over time, it will likely take years to see meaningful market penetration.
We have seen a significant decrease in the effective number of securities How to Mitigate Concentration Risks
in the S&P 500 index, as measured by the Herfindahl-Hirschman While risks are inherent with investing, we believe investors can reduce
Index (HHI). The HHI seeks to measures how many securities it would the overall risks in their portfolio by incorporating key best practices.
take to create an equally-weighted portfolio with the same level of Within the overall equity allocation, exposure to different investment
diversification as the S&P 500 index. This figure is at its lowest level in styles (value and growth) as well as different-sized companies (large
recent history, which means the index itself is thereby also providing the cap, mid cap, and small cap) to achieve broader diversification away
least amount of diversification. from the largest names in the stock market can help reduce portfolio
An overly concentrated market can also have a significant impact on volatility. Beyond style and size, diversification outside of the United
active management and stock selection, as narrow leadership can be States provides exposure to investment trends and the economics in
other growing parts of the world. Additionally, employing a prudent
rebalancing process helps ensure that investors do not get overly
concentrated in any particular asset class or style box.
Because of the robust performance of the Magnificent Seven, portfolios
have generally become overweight to large cap stocks, resulting in
an underweight to small and mid-cap stocks, as well as international
equities. Rebalancing portfolios back to target weights helps reduce
risk and prevent overexposure to high-performing assets, ensuring the
portfolio remains consistent with the investors long-term risk and return
objective.

1McKinsey & Company. (2023, August 25). What is the future of generative AI? An
early view in 15 charts. Retrieved from https://www.mckinsey.com/featured-insights/
mckinsey-explainers/whats-the-future-of-generative-ai-an-early-view-in-15-charts

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