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Diversification – What about the companies?

In our previous post we looked at geographic risk. In this post, we are going to go a bit more granular.

By Jonathon Mannion - Sandringham Wealth - Aug 17, 2020

This is a guest post from Jonathon Mannion. Jonathon is a portfolio construction guru and Senior Financial Adviser at Sandringham Wealth.

In our previous post we looked at geographic risk. In this post, we are going to go a bit more granular.

It’s worth taking the time to think about where we are at present. The first world has largely come through, or is towards the back end of the first wave of Covid-19. The third world is still experiencing a rise in cases. At this stage, there’s no end date in sight, with the second wave beginning to hit developed countries (including Australia) hard!

Manufacturing all but ceased during the first wave. Technology (which had been growing rapidly) was largely unaffected. We all spent more time on Amazon, Facebook, Instagram, the Apple app store with Google the gateway to it all. Covid-19 accelerated trends such as online shopping and working remotely, skewing things further in favour of technology.

Think about what that does to the market. As the majority of the market drops in value, technology only has to hold its ground and by comparison it gains market share. This shows clearly in the makeup of capital weighted indexes like the S&P500.

As its name suggests the S&P500 index is made up of 500 companies.

The largest 5 companies out of the 500 make up 22.55% of the index – Microsoft, Apple, Amazon, Facebook and Google (both Alphabets combined) at 30 June 2020.

The largest 20 companies make up a little over 37%.

Viewed differently:

Is this significant? Quite simply, yes, because as our concentration increases so does the volatility and our risk.

The last time we saw this level of concentration in the S&P500 was in the late 90’s.

Closer to home, we know the ASX is heavily concentrated – it’s banks, miners and healthcare, but as above, let’s put some numbers to it.

The S&P/ASX 300 index is made up of 300 companies.

The largest 5 companies out of 300 make up 28.9% of the index – CSL, Commonwealth Bank, BHP, Westpac and NAB.

The 20 largest companies make up a nearly 57% of the index

If you thought you were buying a broadly diversified basket of companies, consider what impact a drop in a single sector – technology in the US or financials at home could have. Put the sector aside for a minute, what would a drop in just 5 companies have on your investment.

Buying the index is a low cost way to access the market, but given where we are, the risks brought about by concentration are mounting. The consideration now is how to mitigate that risk.

The first step is to look at the strategies readily available to you –

Index tracking, smart beta, equal weighted and actively managed funds.

Strategy 1: Index tracking funds

Using simple, low cost, index tracking funds, you can allocate your investment according to your preferences.

A simple way to do this within a market would be to allocate as follows:

Market CapAllocations
Large Cap*X%
Mid CapY%
Small CapZ%
Total Investment100%

* given the concentration above, you could simply use the broader index for this piece

Depending on the portfolio size you may replicate this on a broader scale by region:

Emerging MarketsC%

Strategy 2: Smart beta

Smart beta strategies can allow you to manage risk more carefully by adding in overlays such as debt and cashflow thresholds. They can also allow you to target or exclude specific areas.

Overlays can be helpful in cutting out risk, particularly in the smaller end of the market. I’m thinking specifically in the domestic market of those companies outside the top 20. You might be prepared to pay a little more in terms of MER for an ex 20 fund or small cap fund as an example which is going to mean that some of the flash in the pan names are excluded.

You could use smart beta to focus your portfolio on a specific criterion such as high dividend income – whilst still managing risk. If you are looking for passive income, potentially as you approach retirement, a smart beta fund may fit the bill.

Smart beta can help you screen for ESG consideration – ethical, social and governance – more broadly known as ethical funds.

Strategy 3: Actively managed funds

This is where you are looking for an investment that does something specific perhaps style based. You may like the Warren Buffet style value based investment, or the more aggressive growth focused fund.

Due to the ease of access, more active managers, traditionally found in the managed fund space are launching ETFs, think names like Magellan, Platinum and Schroders.

Diversification has many layers

Finally, given your level of expertise, time to research and monitor, and your enjoyment, you may choose to blend across strategies to meet more specific needs.

Whichever way you choose to go, be aware of the risks, use the fund screener tool and take the time to read through and understand what you’re investing your hard earned cash in.

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