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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Anyone allocating active capital or doing manager research in the US or global space may be getting a little weary of hearing about the impact of megacap stocks like Google, Apple, Facebook, Amazon, and Microsoft (GAFAM).1 However, given our Fundamental Factor team’s work on manager research and multi-manager portfolios, we know that asset owners are very aware that as the weight of megacap stocks in US and global benchmarks increases, the risk arising from active managers being underweight companies like these increases as well.
These underweights are often a fallout rather than a deliberate view, as active managers tend to allocate away from the largest names in the benchmark to source capital for high-conviction ideas. For this to work, those high-conviction names need to outperform the largest benchmark holdings, creating an alpha hurdle. Over the past decade, that alpha hurdle has increased dramatically. To illustrate this point, Figure 1 shows the annual impact over the last 20 years of not owning the GAFAM stocks for a manager benchmarked to the S&P 500. Notably, the last time being underweight “helped” active managers was in 2008.
We’ve found that active managers often have a high bar to own megacap stocks given the capital needed and the active share give-up. And if active managers do try to manage risk from index concentration, they run the risk of looking too similar to the benchmark. This means an asset owner’s active-risk or active-share objectives can conflict with prudent risk management. Additionally, as megacap names have driven recent benchmark performance, an asset owner’s desired short-term alpha behavior may conflict with longer-term alpha objectives.
As we see it, there are a variety of ways active managers may address this risk:
Ultimately, when managing the risk from market narrowness, we believe it is important for managers to connect risk management with their philosophy and process and to have a robust understanding of the asset owner’s expectations.
1Securities are included for illustrative purposes only and are not intended to be an investment recommendation or a reflection of any particular Wellington holding.