Research Affiliates: Even titans fall
By Joe Steidl, Senior Vice President Europe at Research Affiliates Global Advisors
A handful of stocks with the largest capitalizations drive the performance of a market-cap-weighted index. But these equity titans don’t stay on top for long. Reduce the concentration risk of a passive market-cap tracker by allocating to a smart beta multi-factor strategy.
Titanomachy, the great battle of the Greek gods in which the Olympians displaced the Titans, is one of the most defining moments in Greek mythology. Great stories such as this teach us an important lesson. Here, the lesson is never underestimate how dramatically the playing field can shift, even in the most unlikely of circumstances.
Against all odds, even the most powerful can fail. Like the Titans, the rulers of the equity market — the largest market-cap stocks — can be displaced, and on a regular basis. Thus, investors in these titan stocks, particularly via a highly concentrated market-cap index, often face underperformance.
By selecting a more diversified strategy, such as a smart beta multi-factor index, investors can improve portfolio diversification, across companies and investment styles.
The titan top-dog stocks
Research led by my colleagues Rob Arnott, Vitali Kalesnik, and Lillian Wu shows that the top-dog stocks, the top 10 stocks in the world by market-cap, exhibit significant turnover from decade to decade.
Today’s titans are primarily tech and communications stocks. Given that today’s titans are heavily skewed toward growth companies (Apple, Microsoft, Amazon, Alphabet, Facebook, Tencent, Tesla, Alibaba, TSMC, and Berkshire Hathaway), coupled with the concentration risk of their dominating a large part of a market-cap-weighted portfolio, the argument for long-term underperformance of these (likely overvalued) stocks and the portfolios that hold them has merit.
The titans’ market-caps skyrocketed over 2020 as the global pandemic pushed us all into a more-digital world. The 2020 pandemic-related lockdowns also contributed to a tremendous rise in retail participation in the stock market, leading to some very curious asset-price anomalies over the last year. Greater retail participation introduced a new twist on the potential for a popular stock’s market price to deviate from its intrinsic value.
One example is the growing cohort of ‘Robinhooders’ (named after the commission-free trading platform Robinhood) who have the ability to trade fractions of these shares at extremely low —if any — cost. As of December 2020, the top-dog stocks had a weighted-average valuation multiple of 51.4, five times higher than the remaining global equity universe.
This huge valuation multiple represents a substantial premium for investors in global market-cap-weighted indices. We are not saying these dominating titans are not good companies, but are they worth their current prices?
A strategy to lower concentration risk
In the 25 years from April 1996 to December 2020, the concentration level of a global market-cap-weighted index peaked in September 2020 at 16.6% versus the top 10 concentration of a fundamentally weighted index at 6.9%. For investors concerned about concentration risk, a smart beta multi-factor strategy can be an effective way to lower such risk.
A multi-factor strategy aims to capture the return premiums from each of the factors included the strategy, while smoothing out their respective performance ups and downs through diversification. A multi-factor strategy is less prone to severe crashes when compared to a factor in isolation, and combining the factors into a multi-factor portfolio provides a smoother excess return profile over time.
In a recent study, we illustrated the benefits of blending a multi-factor strategy with a developed market benchmark, a proxy for a traditional passive global allocation. Using the period June 1992–December 2020, a 25% allocation of a multi-factor strategy to the developed market benchmark reduced concentration to 14.4% and increased expected long-term excess return by 0.5%.
Raising the allocation to 50% reduced concentration to 11.9% and improved the expected-return profile by 1.0%. In both blended portfolios, tracking error was below 2.0%. A more-aggressive allocation of 75% decreased concentration to 9.6%, kept tracking error under 3.0%, and raised the historic excess return by 1.5%.
Incorporating a multi-factor strategy in a passive allocation can reduce dependency on large titan stocks and harness the return premiums from well-researched investment factors. The result is a better-diversified passive core allocation with the potential for generating return in excess of the market over the long term.
Disclaimer: please refer to our disclosures