London’s FTSE 100 is ‘substantially concentrated’ as regulator frets over volatility risk

The UK stock market is “substantially more concentrated” than Europe or even the US, analysts have warned, as regulators fret over the clustering of the biggest British stocks on London’s FTSE 100.

In a speech earlier this week, Financial Conduct Authority chief executive Nikhil Rathi warned that market concentration was leading to a “sharp rise in volatility and resulting risk”, noting that just 10 firms represented nearly 50 per cent of the FTSE 100’s value.

“This heavier reliance on fewer firms means disruption – from earnings, regulation, or geopolitics – can trip the global market,” Rathi warned in his speech earlier this week.

This environment poses challenges for stock pickers as they are pushed to have an overweight position in the top stocks in order to outperform the main market.

“Actively managed funds have struggled to outperform top-heavy indexes across many equity markets in recent years, as they do not have sufficient exposure to the largest stocks, either because of restrictions on security level concentration or, as importantly, because they strive to differentiate themselves from the underlying index in order to generate excess returns,” said Michael Born, an investment research analyst at Morningstar.

“Concentration in a few names with an outsize contribution to returns poses a risk to diversification and can encourage herding behaviour, with active managers under pressure to invest in the top names on fear of missing out on returns,” Born added.

Outside of the top 10 stocks, only 30 per cent of the FTSE 100 have beaten the main market since January 2022, according to data from Morningstar.

Born said the UK market is becoming increasingly concentrated because it is heavily weighted to miners, banks, and oil majors, which have performed very well over the last two years as value stocks fell back into favour.

This has also contributed to a rise in the concentration of dividends, with just 10 FTSE 100 companies forecast to pay out 55 per cent of dividends throughout 2024, while the top 20 pay out 71 per cent.

“Investors must be aware of the relative degree of concentration risk within the UK’s headline index,” said AJ Bell investment director Russ Mould.

The FCA currently mandates that funds cannot have more than 10 per cent of their portfolio in a single holding, as well as preventing holdings that each make up more than five per cent of a fund’s assets exceeding 40 per cent when combined.

This ‘5/10/40’ rule has prevented UK funds from becoming too concentrated for years, but has come under fire in recent years as the market moves towards being dominated by larger players.

Terry Smith, the manager of the largest fund in the UK, described the rule last year as a “headache”, complaining that it forces him to focus less on delivering returns than pleasing the regulator.

However, repealing this rule could lead to stock pickers herding into the few largest companies, driving up their share price even more and risking massive ripple effects if even one starts to underperform.

Rathi warned about these ripple effects in his speech, noting that “a small blip can ripple across equities, fixed income, FX, commodities…or more recently, crypto”.

He added that the FCA was examining the dip in markets over the summer after poor US economic data sent global stocks plummeting to determine “if there are new systemic risks needing deeper examination”.

“Volatility per se is not the issue and should not be conflated with systemic risk. But excessive moves, especially intraday, due to runaway volatility that dislocate prices from fundamentals are the central concern,” he said.