Individual savers and investors have benefited from the rise of passive investing as a low-cost option to access a diversified portfolio of the best companies in the world.
As more investors shun more expensive active funds, the amount held in passive strategies has grown.
However, as more money flows into index trackers, it can benefit larger companies disproportionately as many of the most popular benchmarks are constructed and weighted according to market capitalisation.
Source: Investment Association
For example, big tech companies were driving much of the gains for the S&P 500 over the last five years but it was after the coronavirus pandemic that they emerged as clear winners when compared with the rest of the beaten-down economy.
As a result of their success, the five largest companies in the S&P 500 – Apple, Amazon, Microsoft, Facebook and Google (Alphabet) – now account for more than 22 per cent of the index.
Do passive investors face potential concentration risk if almost a quarter of the benchmark that they use to invest in the US – the world’s largest economy – is made up of just five tech companies?
George Lagarias, chief economist at Mazars, said the dominance of big tech “ostensibly presents a concentration risk for investors. However, that sort of concertation does not seem overstated, given the outsized importance of these companies in our everyday lives”.
“This very comment is written in Microsoft product and probably read over an Apple iPhone,” Lagarias noted. “Google (Alphabet), comprises of 90 per cent of internet searches of the world daily and few can doubt Amazon’s value at a time of Covid-related retail crisis.
“If index investing is about proportionally participating in the earnings of the wider economy, current weights don’t challenge it’s fitness for purpose.”
He added: “If weightings were adjusted towards other sectors seemingly to diversify risk, then that proportionality of participation would be effectively challenged.”
However, the Mazars chief economist said a risk that is ‘probably understated’ is the increasing probability of regulatory action, which is inherent in every dominant sector.
He said: “Like banks, energy or even rail before tech, size invites oversight which eventually turns into regulation, lest the sector becomes stronger than the ability of organised states to impose their democratic wills.
“In the next few years, we wouldn’t be too surprised at a tougher regulatory environment for big tech, which could affect longer-term growth and cause these stocks to trade at multiples closer to other index members.”
Craig Baker, global chief investment officer at Willis Towers Watson and chairman of the £3bn Alliance Trust, pointed out that this concentration risk is bigger than what it was just before the dotcom crash of the early 2000s.
He said: “Such concentration can lead to narrow rallies – as we’ve seen over the last two-to-three years – which leads to increased risk.”
Baker is concerned over the skew towards the largest five companies and is worried about the contrast between how well they are performing in comparison to the remaining 495 stocks in the index, most of which are down year-to-date.
Market capitalisation of five largest companies as a share of S&P 500 total
Source: Alliance Trust
Baker said: “In 2018 and 2019 the average stock underperformed by 5 per cent. In the first half of 2020, it was over 7 per cent. Whereas from 2011 to 2017 the average was more like 1 per cent.”
“You get a little bit of survival bias, so you might expect a tiny bit of underperformance, but you don’t expect anything quite as extreme as that,” he said. “It is hard to believe that will carry on forever.”
The Alliance Trust chairman contrasted how the 200 companies within the trust’s portfolio are quite evenly weighted as opposed to the index.
“What you tend to find that’s there are a lot of companies that are about 0.8 per cent of the portfolio. We don’t have many that are tiny, we don’t have many that are massive,” he explained.
He said on an absolute return basis one could argue that it’s lower risk than a passive approach in many ways because of how tiny the weightings are in the index.
“It’s got loads of companies but some of them are like 0.01 per cent of the index, they’re not really having much impact in the diversification point,” Baker added. “Buying the index is less diversified than people think it is when you actually take into account the concentration that it’s got in the very largest companies.”
However, he admitted that the trust does have one or two companies that are quite large – it has 3.2 per cent in Microsoft and 2.9 per cent in Amazon: “But that’s not because they are large part of the index, it’s because a number of mangers find them attractive at the moment.”
And the concentration and skew of the biggest companies in index trackers was one of the many reasons why Baker thinks investors should be considering active equities as opposed to passives.
Scott Glasser, chief investment officer at ClearBridge Investments, said that highly concentrated portfolios – in the right sectors – would have been where the best returns would have been made more recently.
He explained: “Quite honestly if you’ve had any kind of diversified portfolio you’ve probably underperformed your benchmark.
“You’ve wanted to be highly concentrated and you’ve wanted to have primarily tech-orientated consumer communication-type plays, with big positions, highly concentrated, which is not what most people are.”
Glasser added: “I really question the utility of some of the cap-weighted indexes certainly on the growth side when you’ve got such concentration and there are value investors who are trying to invest in a diversified portfolio as opposed to a concentrated portfolio.”
In addition, he said that over a multi-year period overlooked sectors like utilities will come back into favour due to “the appeal of a 3-4 per cent dividend that is pretty secure and is growing in a zero-interest rate environment”.