The ASX 200’s concentration is closer to normal than it looks

Concentration usually reaches investors framed as a fault. In that telling, the Australian market has drifted into it, and the index has failed to correct it.

Sean Freer, Director, Global Exchange Indices at S&P Dow Jones Indices, argues this perspective misconstrues the historical data.

The top 10 companies in the S&P/ASX 200 sit at just under 49 per cent of total index market capitalisation. That compares with an average of about 48 per cent across every quarter-end since the index began in 2000. The range around that average is wider than most investors build their portfolios to expect. The top 10 have been as low as 40 or 41 per cent, and as high as about 56 per cent just after the mining boom in 2013.

Fluctuation is the index’s normal condition rather than a departure from it. A point above the long-run average is not the distortion many take it for.

Not a flaw

The weight of the largest names is only half of what an investor is buying. Those 10 companies span five sectors. While financials and materials together account for more than half of the S&P/ASX 200 and the S&P/ASX 300, healthcare, industrials, consumer discretionary, real estate and energy all carry reasonable representation. The real gap is information technology, which sits at around 2 per cent of the index across nine companies.

“I don’t think concentration in stock market indices is a flaw of an index or an index design.”

A narrower index concentrates by construction. The fewer companies an index represents, the more concentration follows. A broad market index reports what the market is doing, including the parts of it that look stretched.

Crowded trades have left stocks and sectors carrying more of an index than investors would call a fair weight. Freer’s position is that judging that belongs to the investor rather than the index. Anyone who thinks technology is over-represented in global equity indices can own an ex-technology portfolio or an equal weighted version of the same market, and trade on the view.

Australia’s shape is also less unusual than the domestic conversation suggests. Taiwanese indices carry more than 70 per cent in technology after the semiconductor rally of the past 18 months, and Korea is not far behind. Singapore holds more than half its market in financials alone. Canada leans on financials and miners much as Australia does.

Only the three largest markets, the US, China and Japan, have thousands of liquid investable companies spread across every sector. Even the US carries a well-documented technology tilt.

The winners

The stronger argument for holding the whole market sits in the distribution of returns rather than in the weight of the top 10.

Over the 12 month period to June 30, fewer than half the companies in the S&P/ASX 200 beat the index return. The longer the window runs, the smaller that group becomes. S&P DJI’s work on the frequency of constituent returns finds the same pattern over five, 10 and 20 year periods. A shrinking number of companies drives the outcome.

“We don’t know what companies they’re going to be unless we go back in time,” Freer says. Businesses mature, lose a competitive advantage and give up their place. That is what makes identifying the eventual winners in advance so difficult, for private clients and professional managers alike.

The toolkit

Investors do not have to answer concentration by abandoning the index. S&P/ASX equal weighted, capped, mid and small cap indices all change the shape of the exposure. So do dividend series, value and growth, and factor families such as low volatility, momentum and quality.

Some clients have held the major banks directly for decades, and selling would trigger capital gains. For them, the useful point is that they no longer have to assemble the rest of the exposure stock by stock. “In this day and age, you really don’t need to buy individual securities if you don’t want to,” Freer notes.

The weight of the top 10 will keep moving with the cycle, and the sector weights along with it. The advisers who can show a client exactly what their Australian holding does and does not own are the ones best placed to decide what should sit beside it.