Rising concentration risk in passive investing
Passive investing has become extremely popular in recent years, evidenced by significant industry flows and an ongoing proliferation of new instruments on the market. Passive strategies can play an important role in portfolios for some investors, providing cost-effective exposure, particularly to more efficient markets where consistent alpha is harder to find. Indeed, many investors opt for passive strategies to add diversification to portfolios. However, recent market dynamics are prompting some reflection on the assumption that passive index-tracking strategies will always provide good diversification.
Beware of bad breadth
Some of the world’s major indices are becoming more concentrated, meaning the passive strategies that track them are becoming more exposed to the fortunes of fewer companies from fewer sectors. It’s no secret that equity markets such as the US have been driven upwards in recent years by an increasingly narrow set of stocks - and this trend towards decreasing breadth extends to other indices across the global landscape.
As the below chart shows, the weight of the largest ten companies in the MSCI All Country World Index (MSCI ACWI) has risen steadily since 2016 and now stands at roughly 15%. And while concentration has been this high before in the early 2000s, back then the largest companies came from a broader range of sectors, with no sector making up more than 5% of the index. Today, Apple alone makes up nearly 4%, while the ten largest companies in the MSCI ACWI come from just four sectors - information technology, consumer discretionary, communication services and financials.
In addition to the greater single stock and sector concentration, because the largest companies come from the US, regional diversification has also fallen. In short, investors in the MSCI ACWI today are much more exposed to the fortunes of a small group of stocks in a small number of sectors from one country.
Trend towards concentration has been in place for some time
The global pandemic has no doubt accelerated this trend as investors sought liquidity through the largest companies during a volatile period. However, this trajectory towards increased concentration began in 2016 and has strengthened into 2021.
Of course, higher concentration can come with upsides as well as risks. If the largest names in the MSCI ACWI keep rising faster than the broader market indefinitely, passive strategies that track this index will perform strongly, as we have seen in many contexts in recent years. However, the obvious downside is that investors are exposed to an increasingly narrow group of companies from a small group of industries, many of which have business models that are deeply connected. If a negative shock affects one of them, it is likely to affect them all.
Consider a manager of an active fund who let winners run this far without taking profits, and in fact continued to invest more: they would rightly expect to have their risk management process questioned.
Concentration is neither good nor bad in isolation, but it can be dangerous when investors are exposed to it unwittingly while thinking they are well diversified. Today’s rising concentration means that many passive indices may be less diverse than investors think, leaving them exposed to specific risks, such as tougher regulations of US technology companies. By design, passive strategies cannot anticipate these shocks and must participate in the price action. We believe that allocating to passive instruments therefore requires scrutiny of an index as well as the characteristics of any given instrument.
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Anthony Doyle is Head of Investment Strategy for the Firetrail S3 Global Opportunities Fund. His primary responsibilities include fundamental idea generation, portfolio analysis, and economic insights including currency and macroeconomic risk...