How to avoid concentration risk when investing

Concentration risk.

It is something that all investors, large and small, have to wrestle with as they try to get exposure to share markets in the most diversified and cost-effective way.

The Australian share market is one of the world’s great examples of concentration risk, with the dominance of the financials and materials industries carrying much more weight when you are exposed to the ASX 200 index through an exchange traded fund (ETF) such as those from Betashares (ASX: A200), BlackRock (ASX: IOZ) or SPDR (ASX: STW).

Banks and miners dominate locally

When you look at the ASX 200, the big banks and miners dominate the weightings, making up more than half of the market index.

That can be great at some times but can also lead to your investments lagging significantly should one or both of these major sectors hit tough times.

Historically, Australia was a bit of an outlier with such a significant concentration risk but recent moves in the global large cap space have seen the concentration risk spread to other stock exchanges, even the once highly diversified S&P 500 in the United States.

Magnificent seven have produced concentration

The incredible boom in the US market by the so-called magnificent seven stocks (Meta, Microsoft, Tesla, Alphabet, Amazon, Nvidia and Apple) means that these massive companies now represent around 30% of the S&P 500 index.

That has led many investors to question whether it makes sense to simply remain heavily exposed to these large company stocks given their recent outperformance relative to the market.

You don’t have to go back too far to see that such a concentration risk is very real.

While the magnificent seven delivered sizeable returns to investors in calendar year 2023, calendar year 2022 was quite different as they substantially underperformed the other companies in the S&P 500 index.

Annual returns diverge according to size

Looking back even further over 30 years you can see that average annual returns have diverged quite dramatically when looking at large and small company shares, with small companies significantly outperforming large companies in the early 2000’s.

What this shows is the risk of remaining too concentrated on a smaller number of shares, with a more diversified approach of being exposed to a range of different sectors that can produce a higher expected return over the long term with significantly less risk.

This is a lesson most direct investors already know well – if you own a small number of stocks you can easily miss out on some of the market performance which is being produced by some star performers that are not in your portfolio.

That is not to say that taking a concentrated approach is not a viable strategy – many of the world’s great investors run highly concentrated portfolios – but merely to point out the risk of unconsciously being more concentrated due to sector domination in indexes.

Capturing all market sectors

It is also quite important to capture all segments of the market and not just the large companies, with the long-term average return for smaller company stocks higher than the average return of larger company stocks.

This is sometimes called component investing, using a strategic position in each component of the market such as large, medium and small company shares and then using rebalancing as the tool to take profits during periods of outperformance and topping up the unloved component when it is cheaper.

As you might expect, the flood of new ETF products has produced a number of answers to this concentration risk with some offering exposure to different sectors such as small companies or specific market sectors and others using what is called “equal weighting” to ensure that they mitigate against the concentration risks of market weighted index ETFs.

Equal weight approach creates different results

Equal-weighted ETFs don’t allocate larger companies a larger piece of the ETFs weighting, with all companies in the index, regardless of size, treated equally.

Should a company grow its portion of the index, it will be actively sold down at a rebalancing date (usually quarterly) so that it still retains the same weight in the fund.

The same applies to a company that might fall a lot, with more of its shares being bought at a rebalancing date.

Usually, these equal weight ETFs have higher management fees to deal with this amount of trading, which should be borne in mind when investing in them compared to vanilla index funds which tend to have very small fees.

Local and international examples

One of the local ETFs is the VanEck Vectors Australian Equal Weight ETF (ASX: MVW), which invests on criteria including having a market cap above US$150 million, meeting a liquidity requirement of a three-month average-daily-trading volume of at least US$1 million and at least 250,000 shares traded per month.

All of the qualifying companies are assigned an equal weight in the fund which is maintained over time – assuming the company still meets the liquidity and size filters.

Another example, this time locally listed but covering the US market, is the BetaShares S&P 500 Equal Weight ETF (ASX: QUS).

As you might expect, the results from such equally weighted ETFs are different from those obtained by an index exposure.

Different results in different markets

The VanEck methodology would have consistently produced higher returns than the ASX 200 over the past five years while the BetaShares methodology would have underperformed the S&P 500 over the past five years.

That provides an interesting point of reference.

For the already concentrated Australian market, an equally weighted approach produced better returns but in the US market where a handful of shares were growing quickly to dramatically concentrate the index, a similar approach underperformed.

Should the concentration of either index fall, you would probably expect both equal weight ETFs to do well, while further concentration might harm their chances.

Either way, the equal weight approach is an interesting wrinkle that all investors searching for some true market diversification might want to consider.