Investor Beware
Around the same time as the rock band The Who sang “meet the new boss, same as the old boss” indexing was already becoming a thing in the investment world. Today, the old boss is now the new boss and the benefits supposedly derived from indexing have withered under its own success.
Over the past 12 months, choosing to invest in an S&P 500 index fund has meant making a particularly heavy bet on the top five names in the index. Because it is a cap-weighted index, as the five trillionaire stocks have increased in value over the last several years, the influence of their performance on the overall performance of the index has grown significantly.
These stocks (GOOGL, AMZN, FB, MSFT, and APPL) currently make up 22.8% of the S&P 500. That means that 1% of the names of the index account for almost a quarter of its performance. It also means that an investor seeking diversification and protection from market volatility is highly exposed to technology, e-commerce, the cloud, and the metaverse (yes, our eyes are rolling too). All of these themes have performed admirably in recent times, but the goal of diversification is to minimize risk concentration. An investor in the S&P 500 cannot now be seriously considered to be diversified.
It's hard to think about the diversification benefits when markets have done so well for so many years, but as inflation creeps, we suspect a lot of investors will start to wonder how protected they really are. The chickens will come home to roost when they realize all their eggs were in one basket.
With indexing abdicating its diversification benefits, it opens ample opportunity to develop new approaches to creating a diversified portfolio for the twenty-first century. So how should investors think about diversification now that S&P 500 has become the new boss offering nothing better than what came before?
We believe the future is a synthesized blend of fundamental and systematic processes. For example, we examine values and fundamentals in the first two stages of our security selection, and then our portfolios are optimized to maximize diversification and reduce correlation. This discipline has resulted in significantly lower risk concentration compared to the S&P 500. Currently, our large cap core ESG strategy contains none of the top five names in the S&P 500, based on market capitalization. Furthermore, the top five names in the our strategy make up only 17.62% of the portfolio, versus the 22.8% in the S&P 500.
Correlation should also play a key concern in the portfolio construction process. It is important to make as many independent bets as possible such that winners offset losers and skill is realized. The correlation of the top five names in the S&P 500 is 0.71; we keep our strategy low at 0.33 because of our focus on making as many independent bets as possible.
Diversification that is making independent bets can help investors weather bear markets in large concentrated sectors. This also decreases volatility – the S&P 500 is expected to have a daily volatility of 1.57%, vs. the 1.31% expected for Stance ESG Large Cap Core Strategy.
Historically we see the effects of optimized diversification in the beta and down capture statistics for the fund. Historically Stance has had a 0.83 beta, and a down capture of 71.39%. The diversification and risk optimization has enabled us to have a lower downside deviation of 4.05%, vs. the S&P’s 4.64%.
Critics sometimes argue that the addition of ESG criteria to the investment process reduces diversification and makes active risk management more difficult. Based solely on our track record of nearly eight years, we beg to differ. With proper portfolio management, diversification, and optimization, values alignment can be free.
-Kyle Balkissoon, Managing Partner, Stance Capital
kyle@stancecap.com