How to avoid concentration in your portfolio

  • Describe some of the challenges relating to concentration risk
  • Describe how certain stocks have become concentrated in funds and indices
  • Identify how to mitigate the concentration risk
How to avoid concentration in your portfolio

The spread of Covid-19 over the last few months has led to widespread volatility across global financial markets and an economic slowdown that is likely to take many years to recover from.

While we are now seeing some more positive news as progress has been made with vaccines and many countries are lifting their lockdowns, we are still living in very uncertain and disruptive times and will be for some time.

While this pandemic is in many ways unprecedented, history has shown us that in challenging markets, it is crucial to diversify assets. The coronavirus is a global crisis that has affected numerous regions and sectors.

However, we can clearly see that different countries are at different stages of progress in reducing case numbers and returning to ‘normality’ based on their individual handling of the virus – be it severe lockdown measures or significant fiscal and monetary policy.

In addition, any progress feels fragile with fears that a second wave could be on the horizon. With the future unclear for many countries and their economies, the desire to spread investment risk across multiple geographies and asset classes is understandable.

The regional allocation of model portfolios, multi-asset funds and discretionary managed portfolios has become an increasingly hot topic during our conversations with financial advisers.

However, we believe that in the pursuit of well-balanced investments and strong risk-adjusted returns, many advisers may be inadvertently exposing their portfolios to accidental concentration risk.

The concentration conundrum 

This is not a new problem but is one that still surprises advisers when we bring it up. 

If we think back to 15 years ago, many UK domiciled multi-asset portfolios were characterised by a home bias, for example thinking of their exposure as a 50/50 split between domestic and overseas assets.

Within equities, this would mean companies such as HSBC, Vodafone and BP had a disproportional impact on the risk and return of the overall portfolio, potentially dominating the stock specific contribution from elsewhere.

There is now recognition that from an investment perspective, the amount allocated to the UK was too much and this has gradually been reduced in the IA Mixed Investment sectors to become more akin to global market cap. 

In a world where fund management costs are increasingly under scrutiny, investor demand for cost-effective multi-asset solutions has never been higher.

The challenge for advisers and product providers is to continue providing a high quality service, but to do so at a lower cost.

This can be achieved by moving more towards index funds which have much lower costs than their active equivalents. Bringing index funds together in a diversified multi-asset portfolio also greatly simplifies advisers’ research, due diligence and transactional workload.

As a result, advisers increasingly choose index strategies to provide cost-effective well-diversified exposure for equity holdings within multi-asset portfolios.