It is not too late to de-FAANG your portfolio

Image by Free-Photos from Pixabay

By TATJANA PUHAN/TOBAM

If the only alternative to forecasting ability is accessing the risk premium in its purest form, some investors in their search for the beta believe that passive management, defined as the investment vehicles tracking market-capitalization weighted indices, offers access to this beta. There is a myth or misunderstanding that “passive = neutral”.

The shortcomings of replicating market-cap weighted benchmarks

Passive investing, which is often described as beta investing, does not provide neutral access to the risk premium. Investing in a cap-weighted benchmark means buying a portfolio that can be hugely biased to sectors, styles, countries and individual securities. There is ample academic literature to support this.

These benchmarks take on heavy structural biases that evolve over time. They are inherently biased as they attribute greater index representation to stocks or factors as they have appreciated and less after they became cheaper. They represent the sum of all speculations of all market participants and these implicit bets change dynamically over time as the benchmark re-weights assets. Because they attribute greater representation to stocks whose share prices have risen, market capitalization-weighted benchmarks maximize their exposure to the past winners.

As a consequence, they do not offer pure beta or immunity from financial speculation.

Furthermore, because an investor tracking these indices would therefore have to allocate more money to the largest risk drivers, these benchmarks inherently forecast that the successes of the past will be successes of the future.

Chart 1: US Equity Market - Sector Weights

Source: TOBAM calculations - Figures as of June 30, 2020. Key Risks: The value of your investment and the income from it will vary and your initial investment amount is not guaranteed. Allocations are subject to change. Of note, GICS introduced a new sector classification in September 2018, that impacted US sector weights. Please contact us for TOBAM’s view on the reclassification and access to our dedicated dashboard on the topic. Click chart to enlarge. 

As concerns about the impact of numerous macro risks, including ‘trade wars’, slowing economic growth and many other factors affecting the macro environment continue, investors may turn to diversification in an attempt to more broadly spread out their risk exposure.

For investors seeking diversification both within and among broad investment universes using market cap weighted indices such as MSCI US or MSCI Emerging Markets, they may be surprised to learn that these indices today reflect historically high levels of risk concentrations in a few stocks with large weights and whose price movements have increasingly been moving in similar directions.

When it comes to diversification, investors may tend to consider spreading investments out across many securities, sectors, regions, and asset classes. That’s only part of the story; a portfolio is well-diversified if its holdings avoid sharing common, correlated risk.

Examining the current level of diversification in Equity markets

As some investors consider weights as an appropriate measure of exposure, we will examine first the collective weights of the top 5 stocks in US and Emerging Markets equities as of end July:

Chart 2: MSCI USA Universe
Weight Concentration: Top 5 Stocks = Bottom 431

Click chart to enlarge.

Not only is the weight concentration of these leaders in Developed and Emerging Markets indices very high as a proportion of the investable universe, but ….

Chart 3: MSCI EM Universe
Top Weight Concentration: Top 5 Stocks = Bottom 1112

Click chart to enlarge.

Chart 4: Relationships Between the Top 5 Stocks in Both S&P 500 and MSCI EM:

Click chart to enlarge.

…. these charts also show that investing in US or Emerging Equities via passive ETFs is providing very similar exposure as investing in the FAAMG companies and their partners, competitors, providers, all surfing on the same wave.

TOBAM introduced and patented the Diversification Ratio which aims to measure to what extent a portfolio is diversified. Using this measure, we can demonstrate that the overall level of diversification available in these universes is currently at historical lows last observed in 2002. This ratio has been steadily declining in the MSCI US index since December 2014 and since September 2016 in the MSCI EM index, exposing passive investors to a limited number of independent risk factors and thus depriving them of broad, diversified exposures.

Chart 5: MSCI US Universe DR²

Click chart to enlarge.

Chart 6: MSCI EM Universe DR²

Click chart to enlarge.

The currently historically low levels of the Diversification Ratios for MSCI US and MSCI EM indices suggests that investors using ETFs tracking these indices are leaving a lot of diversification on the table. Even worse so, the tech outperformance during the recent market turmoil made US markets even more concentrated.

At the same time, the first clouds arrive on the skies of the big tech companies in EM markets. The underperformance of the EM tech mega caps in the rebound contributed to a slight de-concentration. Is this the beginning of a longer-term trend?

How to invest during a historically high market concentration, along with high economic and political uncertainty?

Given the recent rise in turbulence in equity and bond markets, investors may feel their crystal ball is cloudier than in the past, in fact, in fact, how realistic is the expectation of having a clear and concrete picture of the true economic impact of the coronavirus crisis? After all, the future evolution of the virus spread is, itself, completely unclear. On that basis, how can investors know what even central banks and governments do not?

So, what comes next? As a second phase of the market slump, will signs of a massive consumer crisis become non negligible and be priced into sectors or stocks that have seemed almost invulnerable so far such as the FAAMG? Will a second (or, indeed, third) wave of virus infections send us all back into a lockdown with almost unquantifiable further economic consequences? And for how long can central banks and governments credibly continue to play the white knight?
All what that we know at this point is that we know nothing for certain. The best answer to such uncertainty and a future that we cannot forecast is, most likely, the principle of diversification.

Looking back, a well-diversified portfolio would have prevented investors from being overly exposed to the oil price shock and the massive sector sell-off, while allowing the average investor to take advantage of the true market risk premium in an environment of highly dispersed asset prices. While the art of constructing of a truly diversified portfolio would be worthwhile an article by itself, there is no uncertainty that these basic laws of portfolio construction will continue to be applicable and deliver the true market premium to investors.

TOBAM Core Investments is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily TOBAM nor TEXPERS.

About the Author

Tatjana Puhan, is Managing Director, Deputy Chief Investment Officer at TOBAM. She is responsible for the management of all research and product creation related projects, Co-Management of the Research and Portfolio Management as well as Trading teams based in Paris and Dublin assuring the coherence and application of the investment process. Previous to joining TOBAM, Puhan was appointed as Head of Equity and Asset Allocation for Third Party Asset Management at Swiss Life Asset Managers. In this role, she was responsible for a number of the company’s flagship strategies, most notably its investment solutions utilising systematic and proprietary quantitative approaches, as well as contributing to Swiss Life Asset Managers’ asset allocation and equity research initiatives. Puhan has more than 15 years’ investment experience, worked at a number of leading asset management and private banking businesses while also bringing a strong academic and research background.

Puhan holds a Master’s degree in Finance and Business Administration from the University of Hamburg, and gained her Ph.D. in Finance from the Swiss Financial Institute at the University of Zurich, with research fellow appointments at the University of Zurich, Kellogg Business School (Northwestern University) and the University of Hamburg. She is a lecturer in finance at the University of Mannheim and an associated researcher of the Hamburg Financial Research Center.