When constructing and managing equity strategies for our clients, our starting point some 40 years ago was to likewise draw on first principles, common sense, and dispassionate analysis of data over long periods.
Our Equal Weighted approach to portfolio construction is case in point; this proven means of reducing concentration risk that has largely been ignored by the majority of professional equity investors.
Let us take Australia and the S&P/ASX 200 Index. This index is subject to significant concentration risk.
We have long been bemused by some managers’ approach to weight individual companies by reference to their size; a market cap weighted strategy is favoured by Vanguard and a slew of others since, and by ‘closet’ stock pickers who tend to anchor their portfolios with large market cap companies so as to not depart too much from the market benchmark.
This approach is problematic in Australia, due to the large concentration of big companies in a narrow range of sectors. Consider the following startling statistics for the ASX200 Index:
50% of the Index is represented by the top 10 companies. (11% is invested in BHP alone).
Four of the top six holdings are banks (and five of the top eight)
27% of the Index is Financials.
25% of the Index are Resources / Materials companies.
Let’s start with the underlying assumption of market weighted strategies: larger companies will, on average, outperform smaller companies over time. This relationship has been investigated many times by academics going back as far as 1981, and it has never been found to be accurate. Larger companies often have good past performance but as the adage goes, past performance is not an indicator of future returns.
To the degree that there is any relationship between size and returns, it actually works in reverse, smaller companies outperform larger companies on a risk-adjusted basis. This phenomenon, known as the size effect, is well documented in academic papers from the world’s leading business schools and increases when combined with a quality filter(*).
Market Cap indices were designed to be barometers of overall market performance and were not designed to be the basis of portfolio construction. However, passive fund managers started to track these indices, because the implementation costs were cheap, and they produced benchmark-like returns.
Common sense suggests that diversification is key to managing risk. An equal weighted portfolio provides a higher level of diversification compared to market cap-weighted portfolios. By giving equal weight to each stock, the portfolio avoids excessive concentration in a few large-cap stocks, reducing the risk associated with any single stock or sector.
Given the pressures facing the Australian residential housing market from rising interest rates and questions over the sustainability of the current inflated commodity prices, the concentration of the Australian index should be a red flag for investors.
Whether it is a convenient absence of common sense, or an unwillingness of the financial services sector to depart from productisation and selling products, the empirical evidence strongly supports the application of equal weighting of quality stocks, rebalancing with consistent frequency.
Equal weighting is one of the key risk management tools that Cameron Harrison employs to achieve our aim of real growth and a consistent stream of income over the long term, regardless of rises and falls in equity market.
When considered portfolio construction is combined with a focus on quality – management excellence and financial robustness – our portfolios benefit from a virtuous circle of secondary characteristics, including superior risk attributes, sustainable income, long term capital growth, and inflation protection.
Cameron Harrison have been advising business owners, families and significant wealth investors on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through many economic cycles, both through the good times and bad, by keeping the client at the centre of our business.
For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000 or contact our experts here.