JOHANNESBURG - Concentration risk arises when a portfolio is concentrated in relatively few assets, or one or two assets make up a disproportionately large chunk of a portfolio. Concentration risk is the opposite of diversification. This important aspect of investing is often ignored in the debate about the respective merits of active and passive investments.
Harry Markowitz, who won the Nobel Memorial Prize in Economic Sciences in 1990, famously said that diversification is the only free lunch in investing. Diversification allows you to reduce risk by spreading your investments across various assets.
Some of the events that have swayed markets recently are prime examples of concentration risk. These included the election of Cyril Ramaphosa as the president of the African National Congress, the resignation of key members of Steinhoff’s board and the outperformance of Naspers – thanks to its holding in Tencent. Some investors have benefited from these developments, whereas others have been impacted negatively. Either way, concentration risk has been brought to the fore in discussions about portfolio construction.
Active fund managers have the twofold responsibility of outperforming their benchmark and effectively managing risk, including concentration risk. To do this, they research assets thoroughly and allocate investors’ money to assets that they believe will provide good returns, while not exposing the investors to undue risks.
Passive funds track an index, so there is no interference by a fund manager, except to ensure that the composition of the fund reflects the mandated index.
The JSE has fewer stocks, less sector diversification and is far more concentrated than some foreign stock markets. To illustrate this point, the 10 largest shares in the FTSE/JSE Top 40 Index make up about 66% of the index’s total market capitalisation. In contrast, the top 10 constituents of the S&P 500 Index make up only 20% of the index’s market cap. In the South African context, therefore, some of the diversification benefits of index investing are lost, and the possibility of high stock-specific risk exists.
It is important to note that merely owning many shares, such as the top 100 shares in the FTSE/JSE All Share Index, does not result in efficient diversification, particularly when an overly significant percentage is held in a handful of shares.
Naspers’s astronomical growth over the past decade has resulted in the company dwarfing the other shares in the local broad market indices. For example, it accounted for over 23% of the Top 40 Index at the end of last year. In comparison, the S&P 500’s biggest holding, Apple, was only 3.81% of the index.
Naspers’s exposure alone makes the FTSE/JSE broad market indices too concentrated and potentially overly volatile for most investors’ liking. Naspers’s overly concentrated position has counted heavily in favour of investors who invested in index-trackers. The company has returned 45% a year over the past five years.
Risks are often identified well in advance, but attractive returns result in investors ignoring these risks until they materialise and wealth is destroyed.
So why are so many investors ignoring this obvious risk? The inability to counteract emotion-driven investment behaviours such as greed usually tops the list.
Concentration risk is not only relevant to individual stocks, but also pertains to sectors. Active managers can be over- or under-weight in certain sectors. They can use currency derivatives to mitigate the effects of uncertain events, a tool that is not available to passive managers.
The growth of exchange traded funds and passive investments may be compounding concentration risk by indiscriminately buying shares with the largest weight in an index. The increase in the demand for these shares pushes up the price, which, in turn, increases their representation in the index.
Passive managers are often quick to highlight that only a relatively small percentage of active managers consistently outperform their benchmark indices. What is not mentioned, and what is highly relevant in the local context, is that active managers might be taking less risk, particularly concentration risk. They also have the discretion to move into defensive shares and sectors when broad market valuations are high, thereby offering some protection if a bear market or market correction occurs.
Marcel Roos is a fund analyst at PSG Wealth.
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