BUSINESS NEWS - Concentration risk is the opposite of diversification, where your investments are concentrated in relatively few assets. 

When a portfolio is concentrated in relatively few assets, or one or two assets make up a disproportionately large chunk of your portfolio, it gives rise to concentration risk. 

This is an important aspect of investing that is often ignored in the active-passive debate.

Nobel prize-winning economist Harry Markowitz famously said that diversification is the only free lunch in investments. 

Diversification allows investors to reduce risk by spreading their portfolio investments over various assets.

Some of the events that swayed markets recently and last year were prime examples of concentration risk. These include the election of Cyril Ramaphosa as the president of the ANC, the resignation of key Steinhoff board members, and of course Naspers, which continued to outperform thanks to its holding in Tencent. 

In these scenarios, some investors will have benefitted, while others may have been impacted negatively. Either way, concentration risk has been brought to the forefront in portfolio construction discussions.

Active fund managers have a twofold responsibility of outperforming their benchmark, while effectively managing risk, including concentration risk.

To do this, they research assets thoroughly and allocate investors’ money to assets that they believe will provide good returns, while not exposing the investors to undue risks. 

Passive funds track an index, so there is no interference by the fund manager, except to ensure that the composition of the fund reflects the mandated index.

The JSE offers far fewer stocks, less sector diversification and is far more concentrated than some other stock markets overseas. To illustrate this point, the ten largest stocks in the FTSE/JSE Top 40 Index make up around 66% of the total index market cap. 

In contrast, the top ten constituents of the S&P 500 Index make up only 20% of the total index’s market cap.

Some of the positive diversification benefits of index investing is therefore lost in the local context and a possibility of high stock-specific risk exists. It is important to note that merely owning many shares, such as the top 100 shares in the ALSI, does not result in efficient diversification. Especially when an overly significant percentage is held in a handful of stocks.

Naspers’s astronomical growth over the last decade has seen the company dwarf the other counters on the local broad market index, accounting for over 23% of the FTSE/JSE Top 40 index at the end of last year. 

In comparison, the S&P 500’s biggest holding, Apple Inc., was only 3.81% of the index. Naspers’s exposure alone makes the FTSE/JSE broad market indices too concentrated and potentially overly volatile for most investors’ liking. 

Naspers’s overly concentrated position in the index has counted heavily in investors’ favour who chose to invest in index trackers. The company returned 45% annualised per annum over the last five years. 

All too often risks are identified well in advance, but attractive returns cause investors to ignore these risks until the risks materialise and wealth is destroyed.

So why are so many investors ignoring this obvious risk? Not being able to counteract emotional investment behaviours like greed or panic usually tops the list.

Concentration risk is not just relevant to individual stocks, but also pertains to sectors. Active managers are able to over- and underweight sectors. They can even use currency derivatives to mitigate the effects of uncertain events, tools which are not available to passive managers.

The growth of ETFs and passive investments may be compounding concentration risk by indiscriminately buying the stocks with the largest weight. 

The increase in demand for these stocks pushes the price up and in turn increases the representation of the stocks in the index.

Passive managers are often quick to highlight that only a relatively small percentage of active managers consistently outperform their benchmark indices. What is not mentioned, and which is highly relevant to the local context, is that active managers might be taking less risk, especially concentration risk. 

They also have discretion to move into defensive shares and sectors when broad market valuations are high, therefore offering some protection should a bear market or market correction occur.

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