Beware of benchmark concentration

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.

Gauging the alpha hurdle

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.

Figure 1

What can managers do?

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:

• Deliberately do not act — Asset owners may be looking for a manager to play a specialized role in relation to their other allocations, so increasing the weight to megacap names for risk-management purposes may be contrary to their expectations. This option would be more challenging for a core manager with the primary goal of beating the benchmark as often as possible.
  
• Set a maximum risk level — This may entail working with a risk manager to set a range or percentage of the active risk budget allocated to these names. The target risk level should relate back to the manager’s philosophy and process, asset owner expectations, and expected sources of excess return.
• Immunize the portfolio — Seek to take the risk out by matching the benchmark weights, then let high-conviction names drive alpha. We think of this as similar to matching duration in a credit selection portfolio. The overall risk will be lower, but the sources of risk should be more in line with bottom-up selection.
• Bet on mean reversion — Stocks with big index weights have historically found it challenging to keep their competitive advantages and have tended to mean revert. Managers might, therefore, intentionally underweight the megacap names if they believe in the potential for mean reversion.
• Compare relative risk to upside — Compare the risk and fundamentals of a big index weight to the next additional idea: Does the potential upside of the additional idea beat the risk/return trade-off of a highly rated megacap name?

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.