Custom index specialist, Scientific Beta, has mooted two potential benchmark-tweaking strategies for diversified investors in times of sky-high equity market concentration.
In a recent paper, the institutional index-maker suggests investors could either allocate a certain portion of factor-based portfolios to “mega-cap” companies or reweight stock holdings “to closely align with the market cap benchmark”.
Authored by Scientific Beta index director, Daniel Aguet, and head of investment solutions Australasia, Warwick Schneller, the study says either method would increase exposure to mega-caps while maintaining some factor diversification but with different risk attributes and trade-offs.
Under the ‘completion’ approach, investors would have a 30 per cent exposure to mega-cap stocks (defined as the top 5 per cent cohort) while allocating the remaining 70 per cent in a standard multi-factor diversified index-based portfolio.
Meanwhile, the ‘market-focused’ model involves reweighting the multi-factor index via a three-step process that tilts “stocks to closely align with the market cap benchmark and to ensure that sector allocation and market beta characteristics remain close to the benchmark”.
The report says the market-focused style is more closely aligned with ‘information ratio’ targets – or active management risks – while the completion portfolio suits investors with a “Sharpe ratio objective” to outperform a risk-free asset benchmark.
In a back-test during periods of varying US share market concentration levels dating back to 1970, Scientific Beta found the two different settings significantly reduced market cap index underperformance in top-heavy times compared to a regular multi-factor diversified portfolio.
For example, the completion and market-focused portfolios underperformed the S&P 500 index by -0.64 per cent and -0.2 per cent, respectively, on average each year as concentration increased compared to the -4.21 per cent lag of an untreated multi-factor approach.
“The results indicate that both mitigation strategies are effective at addressing concentration risk,” the study says. “Obviously, this comes at the cost that in periods of decreasing concentration, they outperform less than the diversified multi-factor portfolio.”
As concentration declines the regular diversified multi-factor portfolio beat the market-cap index on average by almost 8.9 per cent while the completion and market-focused styles outperformed by a respective 3.34 per cent and 4.59 per cent.
In periods of ‘stable concentration’ all three factor-based models exceed market cap-weighted returns across a range of 1.07 per cent to 1.79 per cent.
Scientific Beta data shows US stock market concentration is currently at highs not witnessed for more than 60 years as the so-called ‘magnificent seven’ companies dominate returns.
“The effective number of stocks sank to 61 by the end of 2024, reaching levels not seen since the 1960’s,” the report says.
Schneller said while the recent stock sell-off may have diluted market concentration somewhat, the trends can ebb and flow over long periods.
“Concentration trend changes tend to be slow,” he said. “It took 10 years to get to where we are today.”
But he said Scientific Beta expects diversified multi-factor portfolios to outperform market-cap indices over the next decade.
The firm, now owned by the Singapore Stock Exchange, builds custom factor-based indices to meet the specific needs of each institutional client. As well as creating a bespoke mix of six factors – size, value, momentum, volatility, profitability and investment – Schneller said the design can also accommodate client preferences around sustainability, for example.
He said research such as the market concentration study would feed into ongoing efforts by Scientific Beta “to build better solutions as we learn more about markets”.
Following an almost eight-year stint with factor manager Dimensional Fund Advisors in Australia, the Sydney-based Schneller joined Scientific Beta last December to drive research and spearhead growth in Australia and NZ.