As stock market concentration hits record levels, ISIS calls for a radical rethink on benchmarking
The concentration of the FTSE 100 Index has now hit record levels, with the 10 largest stocks accounting for 54% of the index (and 45.1% of the wider FTSE All-Share) compared to a representation of just 36.4% at 31 December 19861.
Research from ISIS Asset Management, one of the UK's largest investment companies, has also revealed that the index now paints a very inaccurate picture of 'UK plc'. ISIS believes it's time for the investment industry to consider a radical break with benchmarking performance and risk management to indices.
"The current indices are unsatisfactory for all sorts of reasons," said Robert Talbut, ISIS chief investment officer. "In many developed markets they make a very poor proxy for gaining specific geographic exposure to a country, and in virtually all cases, they poorly represent the industrial mix of the country.
"The All-Share: a poor portrait of UK plc Analysis produced by the ISIS strategy team has highlighted the mismatch between the industry sector composition of the FTSE All-Share Index and that of each sector's contribution to UK gross domestic product (GDP)2. For example, financial companies represent around 28% of the stock market while contributing less than 7% of UK GDP. Likewise, the extractive industries represent about 2.6% of UK GDP but have a thumping 15.5% representation on the stock market. "Where this presents problems for investors is with their asset allocation," said Talbut. "You may take a view on the UK economy to drive an investment decision but the simple fact is that buying the typical UK equity fund isn't a very accurate way of getting that exposure." Not only is the UK stock market now heavily concentrated in a small number of large stocks and sectors, but research by ISIS also reveals that only 35% of the sales revenues of FTSE 100 companies are derived in the UK.
In all, there are 22 FTSE 100 companies which generate the majority of their sales outside of the UK with 12 of these making more than 80% of their sales outside of the UK3. "Some of these are excellent companies," said Talbut. "It is, however, simply wrong to keep thinking of them as 'British blue chips'. They are global companies which happen to be listed on the London stock exchange for a range of reasons such as history, tax and access to liquidity.
Some, such as Old Mutual, were listed elsewhere only a few years ago but switched to London. "The illusion of diversification. However, it is in the area of risk management and performance benchmarking (rather than asset allocation) where ISIS believes the indices present the greatest problems for investors.
"The indices are so concentrated, investors in funds which track or are benchmark-constrained are only gaining an illusory level of diversification," said Talbut. "When half of the index is accounted for by just 10 names (and 3 companies alone account for over 20% of the entire market), the impact of the 600 plus other UK listed companies is watered down." "Part of the problem is the 'mantra' of using tracking error as a risk management tool", explained Talbut, "This is actually nothing more than fund management companies limiting the risk of running funds which might seriously underperform the index. This isn't the same thing as managing the risk to the client's capital which is surely what the investment industry should focus on?"
One potential way to counteract the intense 'skewing' effect of having such large index constituents could be to offer weighting-constrained indices where companies or industries are restricted to a certain percentage of the index. "The problem here would be that the resulting re-balancing could offer some unsatisfactory and arbitrary outcomes", explained Talbut. "You could end up with some fairly large exposures to very small companies if they were the only ones quoted from that sector.
"Another alternative would be to weight according to domestic earnings. "The problem here lies in defining 'domestic earnings'," said Talbut, "classifying exports versus imports and gaining up to date data for re-balancing purposes could present real problems. Also, if you weren't able to persuade other countries to move in this direction you could end up with much company turnover unclassified. "Tweaking isn't the answer "Such issues serve to underline some of the absurdities of indexation, which has remained one of the dominant trends in asset management over the last two decades," concluded Talbut. "If you accept that we are now entering a low return, but probably a pretty volatile world, then you should want your managers to try much harder to identify the longer-term winners, and then stick to them. This sits very poorly with buying a company simply because it fits neatly into an index." Talbut argues that one of the key reasons why active fund managers have failed to deliver outperformance against index funds over much of the last two decades is down to 'tracking error' obsession.
"Over the last 25 years 'beta', or exposure to overall market moves, has been over compensated, whereas 'alpha', the ability to actually beat the market, has been poorly identified and incentivised. In other words," said Talbut, "too many active funds have not been sufficiently focused on true stock selection and then delivery of positive returns." "An incremental change from this mindset - in terms of redefining the indices - is not only insufficient but it also misses the point.
What's required is a fundamental shift away from arbitrary benchmarks which are largely historical accidents and which have undergone substantial turnover," said Talbut. "If you ask most fund managers to justify the use of indices they quickly end up confessing that they're used because 'that's just the way we do things round here' or that there's 'nothing better at present'."
"Wouldn't it be better for investors to use benchmarks which actually allowed them to focus upon what makes a good company? Namely, its finances, market position and strategy - and then to buy its stock - and if they really like it, to buy lots? The point is that the benchmark would have to change to one based upon a real economic measure such as inflation. Then the fund manager would need to provide a return in excess of inflation by a certain margin. It seems to me that this would meet the needs of end investors far more than a stylised index, the beating or not of which has little direct relevance for everyday investors."
"While this may be a radical leap, I believe it to be one of the steps required if the industry is going to re-equip itself to meet the challenges laid down by the customer base. I accept it demands some fundamental changes from all industry participants, but I struggle to believe that incremental 'tweaks' to current benchmarks will prove sufficient."