You bought diversification. You're getting concentration

Please note: this interview was recorded Wednesday, 14 January 2026. 

“Does what it says on the tin” is a phrase you hear often when talking about financial products and investment strategies. It’s shorthand for a simple promise: the label matches the outcome.

A lot of the fund-rating ecosystem is built on that principle. If Fund 'A' claims to offer stable income and low volatility and delivers it consistently, year after year, chances are the rating will be high – even if the performance numbers pale in comparison to what’s available via other asset classes.

Furthermore, if Fund 'B' promises stable income and low volatility, but actually delivers wildly variable returns, chances are the fund won’t rate so highly – even if the average return figure over 5 years tops that of Fund A. 

That framework matters because most investors don’t allocate capital randomly. They invest for specific reasons, at specific points in life, and often to play a specific role in a portfolio, such as diversification.

The problem is that markets don’t stand still. And right now, a handful of structural forces are distorting what many products actually produce. The most obvious is concentration. 

The market has been discussing it for years as “all the eggs in one basket” risk, but it’s now showing up in more practical ways: investors buying passive funds for broad exposure may be far less diversified than they assume, and their future returns may be far more dependent on a small number of expensive winners than they realise.

As Allan Gray’s Senior Investment Specialist, Chris Hestelow, put it:

“Investors in these types of very popular benchmarks may think they're getting a lot of diversification, but today they're actually taking some pretty concentrated bets.”

In the interview above, Hestelow unpacks three market distortions, explains the problems they can create for forward returns, and outlines a few ways investors can mitigate the risks without throwing passive investing out the window. You can also read a summary of the interview below. 

The diversification illusion in market-cap benchmarks

Hestelow’s starting point is simple: popular equity indices sound diversified because they hold a lot of names, but their construction can make them far more concentrated than investors expect.

He points out that major indices are market-cap weighted, meaning “the larger the company, the larger the portion it is of the portfolio.” Over time, if a sector, style, or theme outperforms, it becomes a bigger slice of the index, and “that available diversification decreases.”

In Australia, he highlights how concentrated the ASX has become: 

“At the end of December, you have 56% invested in financials and materials due to the size of the banks and the iron ore miners.” 

He adds that large caps have outperformed smaller companies for a decade, leaving investors “putting more money towards the largest 20 names … than you are in the next 280 companies.” By mid-last year, CBA alone was almost 12% of the index. 

In the US, the picture is similar, where the Magnificent Seven have an outsized influence. The kicker is the comparison: “You actually have more invested in those seven stocks, the Magnificent 7, than you do in the next seven biggest countries in that index.” 

The takeaway? Investors who believe they’re buying broad diversification may instead be buying concentrated exposure to yesterday’s biggest winners.

Distortion one: Concentration risk

Concentration, on its own, isn’t automatically bad. Hestelow makes that clear: 

“Concentration in and of itself actually isn't that much of an issue. If you're concentrated in things that are attractive investment opportunities, that's what we try and do as active managers.”

The problem, in his view, is what the market is concentrated in, and why. When index concentrations build because prices have risen - rather than because fundamentals justify it - a portfolio can quietly shift from “diversified market exposure” to a narrow bet on a handful of dominant names continuing to deliver.

This matters for forward returns because the bigger the concentration, the more your outcome depends on a small number of stocks and sectors behaving well at the same time.

Distortion two: Valuation insensitivity

The second distortion is valuation insensitivity: passive vehicles are bought based on size, not value.

Hestelow describes it plainly: 

“The buying decision in a passive approach is being made based on the size of the company, not on any assessment of fundamental value.” 

The implication is brutal. As long as prices keep rising, passive flows keep buying “no matter how expensive it may get on a fundamental basis.”

His local example is CBA. As it became a larger index weight, investors were effectively forced to own more of it. By mid-last year, it was “30 times earnings despite offering quite little forecast earnings growth, the most expensive bank in the world.” 

He adds colour via Allan Gray’s CIO: “Our chief investment officer, Simon Mawhinney, was saying he'd rather stick pins in his eyes than own it at that stage.”

He argued the risk is not just that a stock is expensive, but that benchmark-aware investors can be pushed into owning more of what they may not like, because of constraints like maximum underweight limits to benchmark weights. In short, index design and career risk can combine to amplify valuation risk.

Distortion three: Momentum bias

The third distortion is momentum bias. Not momentum as a formal factor strategy, but a structural tilt embedded in market-cap indices.

“As the price of a company rises and it becomes bigger in the index, you're putting more money toward that name with new incremental dollars,” he says. 

That means investors end up allocating more to “yesterday's winners, as opposed to yesterday's losers.” Meanwhile, underperformers shrink in the index or get removed entirely, making portfolios increasingly reliant on current winners continuing to win.

Hestelow is clear that it works “fantastically well when the money's flowing in and when the trends continue,” but it “can leave investors quite exposed if there's a reversal against the trends that have been winning.”

He points to Q4 2025 as a glimpse of what reversal risk can look like: some expensive index heavyweights in Australia “start to come off,” and globally, "you saw value outperform growth.” He notes Australia also saw small caps outperform large caps, and emerging markets outperform developed markets - all against the dominant trends of the prior decade. “We don't know if it will continue,” he says, but it shows what can happen when leadership changes.

Why relative comfort has replaced absolute risk

Hestelow argues these distortions are made worse by the way incentives have evolved. After 15 years of strong equity returns and relatively shallow drawdowns versus periods like the tech wreck and the GFC, it’s “natural … to start to really think about the risk of falling behind … rather than absolute risk.”

In Australia, he says this has been exacerbated by the Your Future, Your Super reforms pushing allocators toward relative metrics. If they underperform a passive benchmark too much, “they may have to write to their investors and say, ‘We can no longer accept your money.’” His incentive summary is blunt: “as Charlie Munger always always said, ‘Show me the incentives and I'll show you the outcome.’”

Allan Gray’s framing differs: 

“Our definition of risk is the permanent impairment of capital, actually losing money on an investment.”

Solutions: Complement passive with true diversifiers

Hestelow isn’t calling for investors to abandon passive: “I don't think anyone's going to sell out of passive … that's certainly not what we're advocating.” His argument is that “now may be the time to consider some diversifying exposures that could be held alongside.”

His preferred counterbalance is a contrarian approach, because it does “the exact opposite” of passive: it hunts among the names that have shrunk in the index or been kicked out, looking for “overreaction to the downside and fundamental value.”

He illustrates with Service Stream (ASX: SSM): after falling from around $3 to below $1 and being “booted from the ASX 200,” Allan Gray saw value, bought, and later sold after it rallied and was re-included in the index - “We were able to sell back to those passive investors", says Hestelow. 

Broadly, he suggests that some of the ways to bring in complementary exposures include:

• Add complementary building blocks (Australian or global equity funds) alongside passive exposures.
• Consider exposures with a large diversification impact, noting: “a lot of people are surprised to realise that emerging markets are not in the MSCI World Index.”
• Alternatively, add a diversified contrarian fund alongside an unchanged core portfolio.

His final discipline is to be “students of history,” because long stretches of one regime can make people forget alternatives. He closes with a practical reminder: “Diversification is not about more assets, it's about assets that behave differently.”

Learn more

Contrarian investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. Learn more by visiting the Allan Gray website.