CPD: Three strategies to avoid unintended concentration risk


All your eggs in one basket – strategies for avoiding concentration risk.

The Australian sharemarket is structurally prone to concentration risk and many Australian investors display a home bias in their investment portfolios. In this article, GSFM outlines the issues with concentration risk and provides three strategies to avoid it.

Concentration risk can be defined as the risk of amplified losses that may occur from having a substantial portion of a portfolio in a specific investment, sector or asset class.

Using SMSF data[1] as a proxy, at 30 June 2020 the average SMSF account had 26 percent allocated to Australian shares, 23 percent to cash and term deposits, and less than one percent allocated to global shares. Because of the home bias exhibited by so many Australian investors – and within that, a focus on ASX200 stocks – portfolios can be more concentrated in particular stocks or sectors.

The Australian market

The Australian share market is small by global standards, representing less than two percent of world markets. Not only is it small, but it’s also dominated by a small number of large companies.

In fact, when examining the S&P/ASX200 Index, a common benchmark for constructing Australian equity portfolios, the top 20 stocks comprise just over 55% of its market capitalisation.

A managed fund that uses the ASX200 Accumulation Index as a benchmark will generally have a portfolio skewed toward the largest companies in that benchmark.

For an active fund, this tendency toward the largest companies comes because the fund’s performance is generally determined by the size of that fund’s holding in those companies relative to that company’s weighting in the index.

When it comes to passive investment, either through a managed fund or an Exchange Traded Fund (ETF), the fund’s holdings are generally a replication of the relevant index.

Drill down a little further into the top 20 ASX-listed companies, and there is a significant sectoral bias toward financial stocks. In fact, the big four banks comprise 16.5 percent of the ASX200. The other financial stocks rounding out the top 20 are Macquarie Bank (number 13) and ASX Limited (number 19).

Coming in second place are resources companies (combined Materials and Energy), which comprise nearly 25 percent. The ascendency of CSL to be Australia’s largest capitalised stock has increased the weighting of the Healthcare sector to be the third largest sector in the ASX200 Index.

How does this compare to global markets?

A global benchmark

The MSCI World Index, a common benchmark for global funds, both active and passive, is comprised of 1,603 stocks. At 30 October 2020, the largest, Apple, had a free float-adjusted market capitalisation of US$1,8887.34 billion, the first trillion dollar company in the index. Despite this, it represents just 4.33 percent of the index. The smallest had a market cap of just US$947.87 million.

The top 10 stocks provide a somewhat more diversified spread than the ASX as illustrated in figure two.

The top 10 companies make up 17.39 percent of the MSCI World Index, compared to the 40.23 percent Australia’s top ten stocks make up of its benchmark index. Allowing for the vast number of companies within the MSCI World Index, it is significantly more diversified than ASX indices at the larger end.

The US experience

The S&P 500® is widely regarded as the best single gauge of large-cap US equities and there is over USD 11.2 trillion indexed or benchmarked to the index[2]. The index includes 500 leading companies and covers approximately 80% of available market capitalisation.

Interestingly, except for the inclusion of Berkshire Hathaway (and exclusion of AT&T), the top ten constituents of the S&P500 and the MSCI World Index are the same. Despite this, the weighting of each company in the S&P500 has the top ten stocks representing 28% of that index, a smaller concentration than experienced by our domestic benchmark index.

The UK experience

The FTSE100 is a market-capitalisation weighted index of blue chip companies and although the UK is home to some large companies, interestingly none are top holdings in the global index.

While health care stocks dominate the top FTSE100 companies by market capitalisation, overall, health care represents 12.74% of the index. Other sectors with higher weightings include personal and household goods (12.96%) and industrials (10.11%).

How might concentration risk manifest?

There are several ways concentration risk can manifest in client portfolios:

Intentional concentration – you or your client may believe a specific investment, sector or geography will outperform and elect to invest a bigger portion of their investment money into that investment.

Unintended concentration – this may come from holding a range of investments that have similar asset, sector or geographic exposure; for example, a portfolio of blue chip Australian shares, an ASX-200 ETF and an actively managed Australian equity fund may result in significant concentration of top 20 ASX-listed stocks.

Concentration due to asset performance – those investors who bought CSL shares at IPO in 1994 and still hold them have done well. The IPO price was stock-split-adjusted price of $0.76 per share; today, those same shares are trading at a price over $300 per share (at November 2020). A parcel of 10,000 shares that cost $7,400 at IPO is today worth over $3 million and could easily comprise a much greater proportion of a client’s portfolio, particularly if dividends were reinvested.

Concentration due to correlation – some investments are positively correlated, which means that they tend to perform the same way in the same market conditions. This might be the correlation between asset classes – for example, growth assets such as shares and property tend to be more closely correlated than equities and the more defensive fixed income sector. Correlation may result from holding shares in the same industry; for example, the COVID-19 pandemic this year saw banks lose value as the extent of economic damage became apparent. This was a sector-wide impact, rather than something affecting just one or two companies. Geography can also give rise to correlation – an economic downturn in a country or region will generally impact a range of investments in that region.

How can investors avoid concentration risk?

The best way to avoid concentration risk is to ensure portfolio diversification, across assets, sectors and geographies. Being aware of structural issues that can impact the composition of managed investments – such as the concentration of the top 20 stocks in the ASX200 – can help avoid concentration risk.

There are a range of investment options that can help to avoid concentration risk, including:

Domestic and global small caps

Available both globally and domestically, funds focused on mid-cap or small-cap funds avoid the inherent skew towards sectors that dominate the large cap universe.

In Australia, the S&P/ASX Small Ordinaries Index (Small Ordinaries) represents the small cap members of the S&P/ASX 300 Index, excluding those companies in S&P/ASX 100 Index; its top ten constituents by market capitalisation represent 14.7 percent of the Small Ordinaries. The largest, Mineral Resources, is just 1.9 percent of the index.

The MSCI World Small Cap Index has 4,203 constituents. It includes companies with a broad range of market caps, ranging from US$14,430 million to US$33 million, and spans a range of geographies. Its largest stock, Etsy, comprises just 0.25 percent of the index.

There are several factors that make small caps attractive. These include:

  • Smaller companies are often under-researched by stock analysts and therefore potentially mispriced, presenting opportunities for astute investors to cherry pick the best opportunities.
  • Investing in a small cap company in the initial stages of its development, staying invested while it expands and grows, can potentially provide substantial returns. All companies had to start somewhere – the world’s largest stock, Apple, was once a small cap. So was Australia’s CSL.
  • Smaller companies are often the target of merger and acquisition activity, which is generally positive for the company’s share price.
  • Small caps provide diversification benefits to investor portfolios.

Long/short funds

A long/short equity strategy holds both long and short equity positions. If an investment manager believes a company’s share price will appreciate, it can go long and buy shares in that company. Conversely, if the manager believes a company is overpriced or unlikely to prosper due to structural, economic or company-specific factors, they can go short and sell its shares.

A long/short equity strategy seeks to profit from share prices appreciation above the index in its long positions and price declines below the index in its short positions.

There are two primary benefits from employing a long/short strategy:

  1. The investment manager can tap into underperformance of the market by identifying losers as well as winners. Traditional managers leave that information on the table as they can’t do anything with it. A long/short fund unlocks that potential and gets extra returns out of the ‘losers’.
  2. Increased diversification – because of the concentrated nature of the Australian equity benchmark, traditional managers are often forced to take concentrated positions. Rather, the combination of long and short positions potentially enables greater diversification which may help to mitigate risk, particularly in a volatile market.

Invest globally

Not only is the Australian share market concentrated, but it is also small by global standards, representing less than two percent of world markets. Investing globally can deliver access to a broader range of sectors and companies, which provides diversification benefits to investors’ portfolios.

Australia’s business and consumer markets are also small compared to those in other countries. Using the huge uptake in technology throughout the COVID-19 pandemic; while Australia contributed to increased sales of technology hardware, software and services, the much larger markets in the US, Europe and Asia drive those global businesses. It makes sense for Australian investors to participate in that growth.

Investment portfolios can easily fall prey to concentration risk. As long as there is an awareness of this potential, particularly in relation to Australian equities, advisers and investors can take steps to consider other investments that enhance portfolio diversification and reduce the risk of having too big an exposure to a specific sector, asset class or geography.


Take the FPA accredited quiz to earn 0.5 CPD hour:



[1] SMSF quarterly statistical report June 2020
[2] https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview
The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of GSFM Pty Ltd and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. GSFM Pty Ltd, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

You must be logged in to post or view comments.