This profession of ours never stops fascinating me. I absolutely learn something new every day and I am eternally grateful to be able to get access to some of the finest investment minds in the world. As investment analysts and managers using third-party funds to construct our models and portfolios, we have the ability to talk with analysts, strategists, economists, fund managers and specialists. We also benefit from reading their latest thoughts and attending (albeit virtually at the moment) investment conferences to keep us all up to date with the comings and goings of the capital markets.
Markets are constantly changing, investment thoughts are changing, political alterations create opportunities and challenges. Central Bank activity, money supply numbers, inflation and a whole myriad of other data points mean in our job we can never be complacent.
What is defined as success when it comes to portfolio management for instance can also be very challenging. We are living in a world where relative performance and risk management are taking centre stage. Trouble is, in this wonderful investment world of ours we are usually judged on a number of metrics, not all of which are considered mutually compatible. The goal posts constantly change, and different risks pose different threats at different times of the economic cycle. They also have different importance at different times of the economic cycle.
I’ve probably written this before, but if I asked you to name me a car that:
- Can do 0-60 mph in 2.9 seconds
- Pays no congestion charge
- Sits 7 in relative comfort
- Is a convertible
- Can tow up to 3,500 kg
- Brand new costs £6,995
You’d probably be scratching your head or say that this is impossible. But, broken down to the component parts, the answer to the first question is Ferrari 812 Superfast, the answer to the second is a Tesla, third is Land Rover Discovery, fourth Mini, fifth is Range Rover and the Dacia Sandero brings the list to a close. This is what I mean by the goal posts shifting. If you want a 200 mph supercar, it isn’t going to cost £6,995. If you want a convertible, you are not going to be able to fit 7 people in the car and so on.
Different cars have different risks, and the same with different investments. Different investment styles, objectives, managers, geographies, asset classes and so on bring with themselves different risks.
Therefore, I propose to write a number of short pieces relating to the index, with this being the first.
With this in mind, I started to look at one of the most widely used investment benchmarks. A benchmark that replicates (from a market capitalisation perspective) the World equity market. Having taken data back to 2014 and looking at various characteristics on a monthly basis I was amazed to find a number of findings that I felt were worthy of sharing. When looking at the findings below, consider them with an investment “risk” hat on.
As at the end of July, the 10 largest companies in the World Index accounted for 17.21% of the index. Compared to say the largest 100 UK companies that account for more than 50% of the index you could argue that this is less risky. But, when you consider the World Index has over 1,600 companies represented, this is quite a number.
Taking data back 70 months (Q4 2014) the largest 10 have varied between 9.23% and 17.21%. Interesting that the largest allocation to the top 10 is right now. At the end of June, the top 10 accounted for 16.59% and at the end of May this number was 15.90%. The dominance of the ten largest companies in the index is becoming incredibly apparent. How much of a risk is this?
The largest stock in the index is Apple and it has been in the top 10 stocks of the index for the entire time ranging between a low of 1.61% (30 April 2016) and a high 4.23% (31 July 2020). In fact, Apple is the largest stock in the World Index at 4.23%. On 31 December 2019 it was 2.95%. At year end, Apple was the largest stock in the World Index too. Once again, consider the implications from a risk perspective – of the stock and the index. Of course, Apple is a great company, but for a company to be the largest constituent in the World Index and to grow by more than half in such a short amount of time, is this sustainable? Are there extra risks coming to the fore?
The index is under constant scrutiny and rebalances every quarter. It is a standard market capitalisation driven index, so if the share price of a company rises faster than that of the other constituents then its weighting in the index rises proportionately. Since 2014, there have been 20 companies that can claim that at one stage they have been in the top 10 – which goes to show some companies / industries come into and go out of fashion and that this isn’t a static index. As previously mentioned, Apple has been present in each of the 70 months’ worth of data collected. The only other stock that can claim this crown is Microsoft. Four of the twenty can claim less than 10 occurrences with Chevron only represented in one month and Berkshire Hathaway and Pfizer only able to knock up two appearances.
The company with the third most appearances – JP Morgan Chase - has been represented on 59 out of 70 occasions but hasn’t been in the top 10 for the last two months. At the turn of the year it accounted for 1.00% of the index (ranking it the fourth largest company in the world) and its weight fell every month until it fell out of the top 10 two months ago (when its allocation was 0.72%).
Remember, index weights are relative. For instance, if there was a two-stock index and both were £1 on month one, they would equally be worth 50% of the index weight and the index would be worth £2. At month two, assuming one stock had risen to £2 and the other had fallen to 50p, the index would be worth £2.50 – a 20% rise, but one stock would account for 80% of the index, and one 20%. Taking this into consideration, just think of the actual movements of JP Morgan Chase and Apple this year! The market capitalisation of Apple is larger than the market capitalisations of the 6th, 7th, 8th, 9th and 10th largest companies in the world. Combined.
In other pieces, I’ll look at how the country allocations and sector splits have changed where other “risks” will be highlighted. How you choose to interpret these “risks” is down to you, but hopefully the points raised above should show that indices are “markets of stocks, not just stock markets.” The “product” – i.e. the index - can mask a lot of different strengths and weaknesses, so if a passive instrument is bought, please be aware that the underlying components can, and do, change.
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