Super funds risk market concentration in US: Research

While Australian investors have become accustomed to domestic equity markets being dominated by banks and miners, the problem is becoming more prominent overseas presenting a fresh problem for institutional investors.

New research from Scientific Beta found even in an index of 1400 stocks across developed markets, 25% is now represented by just 10 stocks, including tech names Nvidia, Apple, Microsoft, Amazon and Alphabet.

"Historically, Australia was the concentrated market - banks and resources - while going global gave you this very broad, diversified opportunity set. That distinction has now become less obvious," Scientific Beta head of investment solutions for Australia and New Zealand Warwick Schneller said.

"Today you can buy a very broad developed-market index and still have more than a quarter of the portfolio sitting in 10 companies."

Scientific Beta said the intensifying concentration of the global market raises challenges for the common practice of market cap weighting, where constituent weights of stocks in a portfolio are determined by size.

"Concentration can emerge naturally. As market leadership changes, the degree and source of concentration can change with it," Schneller said.

"Sometimes that doesn't matter very much. Other times it matters quite a lot."

The research found that in today's US equity market - which makes up 70% of the global market - the effective number of stocks in the market cap benchmark is at its lowest level since the 1960s.

"The benchmark hasn't changed - but the risk embedded in the benchmark has," Schneller said.

Schneller stressed market cap weighting remains a useful starting point for investors, as they seek diversification abroad.

He said indices based on market cap indices are liquid, scalable and transparent and offer strong historical performance.

Schneller said for super funds subject to the Your Future Your Super performance tests, having an eye on market cap benchmarks also allows them to be mindful of tracking error constraints under the tests and to spend their limited active budgets wisely.

"But the important distinction here is that market cap is a weighting rule. It isn't really a risk or return objective," he said.

"If diversification is an investment objective, it may need to be explicitly built into the weighting process."

The research paper provides systematic frameworks for diversification built around five different weighting schema, aimed at reducing concentration, improving risk-adjusted return and managing implementation.

"We believe the question is not whether to deviate from the benchmark, but how to do it well within your active risk budget," Schneller said.

"Tracking error matters. Implementation matters. And for super funds, benchmark-relative outcomes matter very directly. So, the objective isn't maximum diversification at any cost. It's finding a sensible improvement in diversification within the risk budget you actually have."

Scientific Beta and Financial Standard are owned by ISS Market Intelligence, which is part of ISS STOXX.