Published December 2019
It could be time to de-FAANG your portfolio
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 capitalisation 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 capitalisation-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 – December 31, 2019. 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.
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 markets: FAANG, FAANG, FAANG….
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 today:
Chart 2: S&P 500 universe
Weight concentration: Top 5 stocks = bottom 304
Chart 3: MSCI EM universe
Top weight concentration: top 5 stocks = bottom 1011
Chart 4: Relationships between the top 5 stocks in both S&P 500 & MSCI EM:
Source: TOBAM, Bloomberg. Data as of 12.31. 2019
….these charts also show that investing in US or Emerging Equities via passive ETFs is providing very similar exposure as investing in the FAANG 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 June 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
Sources: TOBAM, MSCI, as of 12.31.2019
Chart 6: MSCI EM universe – DR²
Sources: TOBAM, MSCI, as of 12.31.2019
The historically low levels of the Diversification Ratios® for MSCI US and MSCI EM indices as of end 2019 suggests that investors using ETFs tracking these indices are leaving a lot of diversification on the table.
Is spreading the risk across different regions or countries a solution?
Given the recent rise in turbulence in equity and bond markets, investors may feel their crystal ball is cloudier than in the past and might aim to more evenly split their bets across different regions, thus seeking out geographical diversification.
Portfolio diversification works better when combining lowly correlated strategies among different universes, allowing a portfolio to more fully collect the full risk premium and reduce drawdown risk when compared to market-cap-weighted indices.
One solution would be to invest in a strategy that aims to have the lowest level of correlation among its holdings and thus represents a very diversified portfolio, which is what TOBAM provides via the Anti-Benchmark® strategy.
Chart 7: Anti-Benchmark® Emerging Markets vs. the MSCI EM and MSCI USA: equities correlations (6.29.2011 – 12.31.2019: daily data)
Source: TOBAM, Bloomberg and MSCI. Warning: Past performance is not an indicator or a guarantee of future performance. The value of shares in the strategy and income received from it can go down as well as up, and investors may not get back the full amount invested. MSCI does not guarantee the suitability, quality, accuracy, timeliness, and/or completeness of MSCI indices or any data included in, related to, or derived therefrom, assumes no liability in connection with the use of the foregoing, and does not sponsor, endorse, or recommend TOBAM or any of its products or services.
Chart 7 illustrates that combining passive exposures in US and EM universes would have been correlated at 66% over the last 8+ years; but combining a well-diversified strategy (Anti-Benchmark EM) with an instrument replicating the MSCI US would have had a lower correlation (61%), effectively improving the diversification potential of the combination.
Rarely in the past has so much exposure in both developed and emerging market cap indices been held by so few companies. Consequently, little diversification is available to investors allocating capital to indices that are tracking these benchmarks. The combination of US and EM market cap-based ETFs would effectively consist of compounding similar risk exposures and thus not materially improve overall portfolio diversification in the current environment, as measured by correlations in Chart 7.
Therefore, for investors seeking to minimize drawdown risk and improve risk-adjusted returns over the long term, it could be prudent to add a unique and lowly correlated strategy rather than passive strategies, notably in equity investment universes such as MSCI US and MSCI EM, in order to de- FAANG a portfolio and more evenly capture the market risk premium in these universes.
Disclaimer: This material is solely for the attention of institutional, professional, qualified or sophisticated investors and distributors. It is not to be distributed to the general public, private customers or retail investors in any jurisdiction whatsoever. This document is intended only for the person to whom it has been delivered. Investment involves risk, past performance is not indicative of future results, investors could lose their investment. All investors should seek the advice of their financial advisor prior to any investment decision in order to determine its suitability. TOBAM has continued and will continue its research efforts amending the investment process from time to time accordingly. TOBAM reserves the right of revision or change without notice, of the universe, data, models, strategy and opinions. TOBAM’s quantitative investment process is supported by an extensive proprietary computer code. TOBAM’s researchers, software developers, and IT teams follow a structured design, development, testing, change control, and review processes during the development of its systems and the implementation within our investment process. These controls and their effectiveness are subject to regular internal reviews. However, despite these extensive controls, it is possible that errors may occur in coding and within the investment process, as is the case with any complex software or data-driven model, and no guarantee or warranty can be provided that any quantitative investment model is completely free of errors. Any such errors could have a negative impact on investment results. We have in place control systems and processes which are intended to identify in a timely manner any such errors which would have a material impact on the investment process. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it.