NEPC’s Karen Harding recently guest authored an article for Family Wealth Report, exploring how wealth management firms can thoughtfully navigate the evolving landscape of artificial intelligence — balancing emerging risks with strategic opportunities. View the article on Family Wealth Report’s site here.
How should wealth managers and others allocating assets think about how to play artificial intelligence? To try to answer that question is Karen Harding, who is partner at Boston-headquartered investment company NEPC. She is also the team leader of NEPC’s private wealth practice group. (More about the author below.)
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In recent years, the stock market has witnessed an unprecedented concentration of capital in a select group of technology giants, often referred to as the “Magnificent 7”: Apple, Microsoft, Amazon, Alphabet (Google), Meta Platforms, Tesla, and Nvidia. These firms have been leading the charge in developing and deploying artificial intelligence (AI), predicted to be an essential technology for future business competitiveness.
But the success of the Mag 7 has created a conundrum for wealth management advisors. Maintaining a market level of exposure to these stocks requires significant portfolio concentration; rebalancing away from them may lower portfolio risk, but potentially at the cost of tracking market results. How can advisors ensure that their clients are properly exposed to the potential of AI without taking on too much concentration risk?
As we have explored this issue with our clients at NEPC, we have come to believe that the answer lies less in derisking client portfolios, and more in identifying the right risks to take, given the client’s investment guidelines.
Historic concentration
As of December 31, 2024, Mag 7 accounted for more than a third of the market cap for the entire S&P 500, according to data from Yahoo!. That’s up from 19 per cent only five years ago, in 2019. Stock markets haven’t seen this level of concentration since the Nifty 50 trend of the 1970s.
Exposure to these technology leaders has produced excellent results for investors, but it has also imposed considerable volatility risk. Mag 7’s contribution to the S&P 500’s monthly volatility has risen in tandem with their market cap share, accounting for more than 40 per cent of total S&P volatility by mid-2023.
No matter how innovative or valuable the Mag 7s are, portfolios that are heavily exposed to them take on a wide range of company-specific risks, such as regulatory challenges, management missteps, supply chain disruptions, to name just a few. In addition, investors broadly do not support ultra-high valuations during periods of market or economic instability. Diversification, achieved through regular rebalancing, is the best defense against these risks.
Strategic reallocation
As long as the Mag 7 continue their performance run, advisors will need to be strategic when attempting to rebalance portfolios that are heavily exposed to them. Approaches that reinvest Mag 7 gains into historically lower volatility sectors will dramatically derisk the portfolio – potentially by too much.
In our experience, smart rebalancing doesn’t necessitate exiting the technology sector entirely. Investors can reallocate proceeds to maintain tech exposure while broadening their opportunity set. For example, AI and related trends are expected to create a more favorable environment for select semiconductor firms and chip manufacturers.
Other sectors stand to gain from the adoption of AI and related technologies. The energy sector is experiencing increased demand due to the high energy consumption of data centers powering AI applications. Similarly, the biotechnology sector is leveraging AI for improved diagnostic tools and personalized medicine.
Sectors such as these present alternate opportunities for capitalizing on AI technology – and smart ways to find the right risks in a more diversified portfolio.
AI is not the only trend that offers investors opportunity. Industrials and infrastructure stocks are expected to benefit from government spending and the rehoming of manufacturing capacity to the United States, in addition to improving robotics. And, given recent stock market volatility, don’t forget the value of having cash reserves.
Cash on hand provides dry powder that enables investors to capitalize on price declines in the market. Such opportunistic investments can enhance long-term returns while improving diversification and managing risk.
Guidelines for rebalancing
No matter how unique or unprecedented the market environment is, it’s always beneficial to reiterate why rebalancing is so important. Helping clients stay aligned with their risk tolerance is often the most valuable role wealth managers play: as the adage goes, you make wealth through concentration, but you keep wealth through diversification. The best practices for rebalancing haven’t changed:
- Consistency and discipline: Rebalancing should be conducted regularly and systematically, adhering to a predetermined schedule rather than being triggered by short-term market fluctuations;
- Alignment with asset allocation and risk tolerance: Adjustments should keep the portfolio in line with client’s financial objectives and risk appetite; and
- Tax considerations: Be mindful that selling appreciated assets may trigger capital gains taxes, so it is essential to incorporate those costs into your strategy. Rebalancing is not about eliminating risk but about taking the right risks given client needs and the characteristics of the current market environment. By thoughtfully adjusting portfolio allocations, investors can manage exposure to concentrated positions, enhance diversification, and position themselves to take advantage of emerging opportunities, regardless of market movements.
About the author
Karen Harding brings over 25 years of industry experience and is experienced across all facets of wealth management. Prior to joining NEPC in 2017, she served as managing director and co-head of the investment advisory services team for CTC | myCFO. Harding is also a member of NEPC’s Partners Research Committee and currently serves on the investment committee of the Oregon Community Foundation.