Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 203

Diversification captures the winning outliers

At a conceptual level, diversification is about spreading risk and not putting all our eggs in one basket. Quantitatively, as I’ve previously explained, one of the main benefits of diversification is lowering the volatility for a given level of expected return. Another way of looking at it is that diversification allows an improvement in returns for a given level of risk, either through levering up to our desired risk tolerance or by capturing positive outliers in the return distribution of stocks in the market.

A few stocks can drive the overall index

Both here and abroad, a concentration of stock returns has often driven overall market performance, in that a relatively small number of large-cap ‘winners’ can carry an entire index. One key implication is there is potentially a large opportunity cost of not holding the index or a broad market portfolio, particularly in a bull market, either through attempts at stock picking or trying to diversify using only a few stocks. By constructing a narrow portfolio using a limited number of securities, significant returns might be left on the table.

Much has been written about the underperformance of most active managers against their respective benchmarks, and one possible reason is the degree of outperformance by a relatively small number of stocks. These positive outliers may not have been held or have been held underweight by underperforming active managers, dragging down overall fund returns relative to the index.

To investigate the degree that a small number of stocks drive index performance, let’s decompose the returns in the S&P/ASX200 Total Return Index over the past few years and find out which stocks were the key drivers of index performance during broad market rallies.

S&P/ASX200 Total Return Attribution

Source: Bloomberg. Total returns include reinvested dividends. Past performance is not an indication of future performance.

The table shows that in most return periods in recent years, a few large cap stocks have driven the S&P/ASX 200’s returns. For example, just 4 stocks – CBA, WBC, CSL and TLS – accounted for 51% of the index’s 55.29% total return (4.5% annualised) over the past 10 years, with the average return of just those stocks 256% over the period (13.5% annualised).

Active managers need to pick these winners

There are a number of ways of interpreting the results. One is that large index-beating return possibilities have existed by picking the right stocks in recent years. However, the risk of underperformance and likelihood of failing to include the right stocks are also large because the number of index drivers have been so few.

It would be remiss not to point out that the reverse could well happen during a bear market, where a handful of large-caps could drive the overall index lower. For example, BHP was a particularly large driver of 2011’s market correction and weighed heavily on S&P/ASX200 returns in 2014 and 2015. But assuming we’re taking a long-term view, the market tends to trend upwards over time.

Caution is also needed regarding the nature of market cap weighting, as past ‘winners’ will account for an increasingly larger index share over time, which we’ve seen for the major banks. This may increase the likelihood that yesterday’s heroes could become tomorrow’s broad market villains in a correction, due to the nature of their outsized weightings. Using an alternative weighting strategy to market cap (such as Research Affiliates’ fundamental weighting methodology) can potentially reduce this risk.

If you have a particularly strong view and have confidence in the stock picking abilities of yourself or a fund manager, you should back yourself. However, it’s worth keeping in mind that failure to pick the few stocks that drive an index’s returns could generate significant underperformance.

 

Chamath De Silva is an Assistant Portfolio Manager at BetaShares Capital. BetaShares is a sponsor of Cuffelinks and issues broad market ETFs such as AUST, QOZ, GEAR or WRLD. This article is general information and does not consider the circumstances of any investor.

RELATED ARTICLES

Changing times as share investors settle in for the long haul

Worried about low rates, SMSFs drop banks and diversify

Headwinds and tailwinds, a decade in review

banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Warren Buffett changes his mind at age 93

This month, Buffett made waves by revealing he’d sold almost 50% of his shares in Apple in the second quarter. The sale not only shows that Buffett has changed his mind on the stock but remains at the peak of his powers.

Wealth transfer isn't just about 'saving it up and passing it on'

We’ve seen how the transfer of wealth can work well, with inherited wealth helping families grow and thrive for generations, as well as how things can go horribly wrong. Here are tips on how to get it right.

Welcome to Firstlinks Edition 575 with weekend update

A new study has found Australians far outlive people in other English-speaking countries. We live four years longer than the average American and two years more than the average Briton, and some of the reasons why may surprise you.

  • 29 August 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

Welcome to Firstlinks Edition 573 with weekend update

Steve Eisman, best known for his ‘Big Short’ bet against US subprime mortgages before the 2008 financial crisis, is now long and betting on what he thinks are the two biggest stories of our time: AI and infrastructure.

  • 15 August 2024

Latest Updates

Investing

Legendary investor: markets are less efficient and social media is the big culprit

Despite an explosion in data, investment titan, Cliff Asness, believes the market has become less efficient, not more, over his 34-year career. He explains why, and how you can take advantage of it.

Property

A housing market that I'd like to see

Our housing system isn't working, with prices and rents growing faster than wages, longer public housing waiting lists and more people are experiencing homelessness. Here are five ways to ease the crisis.

Retirement

It isn’t just the rich who will pay more for aged care

The Government has introduced the biggest changes to aged care in almost 30 years. While the message has been that “wealthy Australians will pay more for aged care”, it seems that most people will pay more, some a lot more.

SMSF strategies

Meg on SMSFs: At last, movement on legacy pensions

Draft regulations released this week finally provide the framework for unwinding legacy pensions cleanly and simply for members who choose to do so. There are some caveats though, including a time limit.

Investment strategies

A megatrend hiding in plain sight: defence

Global defence spending has inflected higher, bringing huge opportunity to a group of companies that have already outperformed broader market indices over the long-term.

Investment strategies

The butterfly effect, index funds, and the rise of mega caps

Index fund inflows to the US market are relatively tiny. Yet a new research paper suggests that they have distorted the size of the market's largest stocks to a surprising degree.

Investment strategies

Options for investors who don't want to sell overpriced banks

The run-up in Australian bank stocks has some investors confounded: do they continue to hold them in expectation of further gains - or sell and take profits now? There are alternative options to consider.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.