Concentrated markets: Implications for active management, manager research, and multi-manager capital allocation

Over the last 15 years, our Fundamental Factor Team has conducted in-depth research on market factors and dynamics that can lead to certain structural biases in actively managed portfolios. In 2012, we found that market narrowness and benchmark concentration topped the list. More recently, we did extensive work on metrics that are useful in assessing relative efficiency across markets, and again we found benchmark concentration was a key consideration in allocating capital and assessing active results.

These results are, of course, very relevant today, as allocators and manager researchers wrestle with the effects of a narrow US (and global) equity market driven by mega-cap technology stocks. In this paper, we share our team’s factor-based insights on the impact of benchmark concentration in three areas: active management, manager research, and capital allocation in multi-manager portfolios. We also highlight a variety of tools we believe can help address and provide perspective around the challenges created by a narrow market, including extension strategies, “passive share” analysis, and index completion approaches. Among our conclusions:

Implications for active management

• Active strategies designed for breadth struggle with market concentration — use less-concentrated benchmarks (or create them).
• Hoping for mean reversion in the performance of big benchmark weights can be costly and the skew is not in the manager’s favor.
• Active management alpha may remain robust in areas not impacted by index concentration.
• Avoiding big benchmark weights can make it challenging to align portfolio risks to the manager’s stock-selection edge.
• Extension strategies may be able to capitalize on alpha opportunities while minimizing “hitchhiker risks” like concentration and size.
• A well-defined risk management process is more critical than ever.

Implications for manager research

• Manager style drift is harder to assess in concentrated markets and may be a byproduct of what is not owned.
• Prudent management of concentration risk may present a challenge to alpha targets.
• Passive share analysis can help allocators and managers understand how much capital it takes to be active in large benchmark weights.
• It’s important to verify that stock-specific risk underpinnings align with a manager’s edge.
• Fundamental factors aligned to a manager’s philosophy can help evaluate skill, especially when narrow markets cloud traditional methods.

Implications for multi-manager capital allocation

• When benchmark weights exceed 1%, it becomes harder for a multi-manager portfolio to reflect each underlying manager’s conviction.
• Allocation processes striving for style balance will likely lead to a lower-beta portfolio when mega-cap growth drives markets.
• Passive index completion isolated to big benchmark weights may help “hedge” these risks with a relatively small amount of capital.
• Using a multi-sleeved approach in an extension format can give the allocator the opportunity to build core portfolios that have a healthy amount of stock-selection potential regardless of benchmark concentration levels.

Read more on our research in the full paper below.