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Concentration Risk: Will You Know It When You See It?

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      By Timothy Atwill, Head of Investment Strategy, Parametric

      Seattle - Market-cap-weighted benchmarks are supposed to provide an unbiased view of the investable universe for a given asset class. However, in the pursuit of providing a full picture of the opportunity set, these indexes rarely concern themselves with whether the resulting portfolio bestows too much weight on a given country, sector, or even individual security. For many passive investors who seek to track a benchmark index, this concentration risk could expose them to unintended consequences if that country, sector, or individual security underperforms.

      There is, to be fair, a counterargument to this concern. It roughly says that market efficiency makes the benchmark portfolio the best market exposure, regardless of the unintended concentration. That is, absent any insights, concentrations that exist in the marketplace should be mimicked in passive investors' holdings.

      Yet there are a number of historical cases when the concentration in market indexes became too much for the investment community to stomach and, recognizing that the concentration risk trumped market efficiency, benchmark indexes took actions to constrain these concentrations. Let's look at a few such situations.

      Japan's concentration risk in the MSCI EAFE Index

      The canonical example of concentrations building up in a benchmark was the growth of Japan in the MSCI EAFE Index of developed international equities during the 1980s. The rapid growth of the Japanese economy and its seeming dominance in the technology and auto industries saw its weight in the index shoot up from roughly 10% to over 60%.

      PPAchart1

      Concerns around Japan's concentration in the index started in the mid-'80s when its weight crossed the 40% level. Institutional investors grew alarmed about the resulting massive bet on Japan in their portfolios. As this weight increased, many moved to contain the concentration by transitioning to EAFE ex-Japan mandates blended with all-Japan portfolios or by capping the weight to Japan in their reporting benchmarks.

      These worries were ultimately validated when Japan's equity market went into a long decline starting in the late '80s and continuing for nearly three decades. Today, Japan's weight has dwindled to 25% of the index, and accordingly many of these countermeasures have long been removed. However, this episode shows that, at a certain level, tolerance to concentrations in a passive portfolio is ultimately resolved in favor of diversification.

      Automakers' concentration risk in high-yield bond indexes

      Not all concentration issues have occurred in equity indexes. In May 2005, bonds from General Motors and Ford were downgraded from investment grade to junk status. Both companies represented large swaths of the fixed income market, due not only to their auto operations but also their sizable financing arms and their relatively stable earnings history. Because of this, their addition to high-yield indexes was particularly notable, given the relatively modest size of most high-yield issuers.

      At the time of the downgrade, the two companies represented 11.8% of the Bloomberg Barclays US High Yield Index. Due to a loud outcry by high-yield investors about the extreme level of specific risk introduced by this downgrade, index providers reacted by creating new indexes that limited any single issuer to a 2% weight (for example, the Bloomberg Barclays US High Yield 2% Issuer Constrained Index), and these quickly became the default performance benchmarks for many high-yield managers. Despite the graduation of both automakers back to investment-grade status, this constrained benchmark remains the default index for most high-yield strategies.

      Current benchmark concentrations

      The issue of concentration risk isn't just something for the history books. Current concentrations in several mainstream indexes aren't trivial, as the table below shows.

      PPAchart2

      Investors tend to argue that a market-cap-weighted universe is the preferred market exposure vehicle, given its unbiased nature and buy-and-hold simplicity, and that any concentrations that result are "just the market." Yet as we've seen, history gives us a number of examples of investors taking corrective measures once the degree of concentration got to be too high. What signifies "too high" is a matter of interpretation, but the concerns expressed around these events are strikingly similar—worries about the reliance on a single country, company, or sector for performance and that the market portfolio no longer provides a sensible market exposure.

      Bottom line: While it's up to individual investors to determine at what level they see concentration, these reasons for avoiding concentration seem to be shared by all, and there's ample evidence that investors can generate long-term outperformance by holding a more diversified exposure at the country, sector, and security level.