Concentration sounds like an unalloyed good, right? Well, you can have too much of a good thing when it comes to portfolio construction: experts are now clamouring to warn about concentration risk.

Why concentration risk is furrowing brows
Concentration sounds like an unalloyed good, right? Well, you can have too much of a good thing when it comes to portfolio construction: experts are now clamouring to warn about concentration risk.

One of the first principles of robust risk management is that old adage, not to put all your eggs in one basket (or too many in too few). Index-linked investment products, where one invests in a basket of stocks to replicate an index, are a time-honoured way for investors to achieve diversification across a range of companies, sectors and markets simply and at low cost. You could take positions in thousands of international companies by buying just one “world” index tracker and gain global exposure in just a few clicks.

The trouble is that these ultra-popular investment products are now looking like a source of concentration risk, for both regional and sectoral reasons.

The vital background detail, of course, is the weighting of indices by market capitalisation (valuing a company by taking the total market value of its outstanding shares and multiplying that by the price they are selling for). This means that the more successful a company becomes, the greater proportion of the whole index it represents.

US tech dominance

Not only does this mean that certain companies and sectors come to dominate, but also that certain countries can. The current situation with the US and global indices is a case in point. 

As at end-April 2021, the US has an outsized 58.41% weighting in the MSCI All Countries World Index, up from only 40%[i] at the beginning of the 2010s. Peeling back another layer, we realise that the success of US businesses has been led by tech companies – the same that have just had such a stellar period of growth due to the COVID-19 pandemic. Today, the first seven of the top ten constituents of the MSCI ACWI are Apple, Microsoft, Amazon, Alphabet (C and A) and Tesla. The situation is similar with the FTSE World and others.

It is easy to see how investors who thought they would be cleverly diversified across regions and sectors through a global index fund could well find they are actually highly exposed to both the US and tech. What’s more, their overall concentration risk could be very much higher due to replication of exactly the same issue in other index funds. The largest five companies in the S&P 500 currently make up 19% of its weighting[ii], with Apple, Microsoft, Amazon, Facebook and Alphabet again the usual tech suspects. 

So, what is a savvy investor to do?

Tackling concentration risk

First of all, don’t give up on index funds. These really have been a boon for investors needing to build up diversification in a cost-effective way, and are likely to play a very valuable role in most investors’ portfolios. Active fund managers need to really be delivering alpha (returns in excess of general market rises) to justify their fees.

Second, recognise how concentration risk can arise with index investing and commit to tackling it. This means not investing in funds like a pick ‘n’ mix based on labels and really looking under the bonnet of what you will own. With the funds you already hold, take the time to see if you are replicating positions and layering concentration risk on (and that goes for your partner’s portfolio too).

Third, aim to spread your diversification efforts, but not too much. Rather than plumping for a global fund it may be wise to consider a series of regional funds to make up global exposure in aggregate, and in the proportions you wish. Yet at the same time, consider the minimum number of vehicles you need to achieve this, as there are costs (and confusion) that come from spreading your capital around among vehicles excessively too.

Fourth, you might want to look at index trackers which aim to strip out concentration by rebalancing the constituents of their funds regularly, i.e. by decreasing allocations to outperformers and increasing allocations to underperformers. Note, however, that these tend to do well only over the longer term of five to ten years.

The overall lesson for investors is that although they should certainly take advantage of all the diversification tools at their disposal in the form of funds, a full understanding of their make-up is essential. Keep a close watch on how concentration risk can build in your portfolio and remember that while a clutch of funds might look like sound diversification on the surface, in reality they could be anything but.   

Important information

This piece is for informational purposes only, and is not intended in any way as financial planning or investment advice. Any comment on specific securities should not be interpreted as investment research or advice, solicitation or recommendations to buy or sell a particular security.

Always remember that investing involves risk and the value of investments may fall as well as rise. Past performance should not be seen as a guarantee of future returns.

[i] MSCI ACWI, 30 April 2021

[ii] S&P Global, 10 April 2021

Manish Vekaria
Manish Vekaria

CEO and Founder of ARQ