all insights

Why concentration is the biggest risk to your portfolio

By James Wright |10.25.2022

Do you know what you own?

Portfolio tips: why concentration can be the biggest risk to your equities and bonds investments (

Investing can be complex, and many investors simply do not fully understand what they own in their portfolio and how it will perform under different scenarios.

When Russia invaded Ukraine in February and attracted global condemnation and unprecedented financial market sanctions, many investors were surprised to learn the extent of Russian exposure in their portfolios via global products. Russia represented some 3.2 per cent of the MSCI emerging market equity benchmark and around 1 per cent of the emerging market debt benchmark. Along with these known benchmark exposures, numerous global companies spanning finance, media, food, technology, energy, and professional services had substantial business operations in Russia which were rendered virtually worthless overnight. The loss of capital across the globe has been extensive.

How many investors really knew the extent of Russian exposure embedded in their portfolio through emerging market products or direct company holdings?

Against a sea of investment opportunities across the globe, market indices have become the industry tool to assess expected returns, risk, and the building of ‘efficient’ portfolios. Comprehensive studies have shown that asset allocation is the single most important driver of a diversified portfolio and in these days of specialist investment management, choosing an index or, more importantly, the right index is becoming even more critical.

Benchmarks are designed to reflect a fair representation of a particular market and generally have several design features – including being transparent on the names and weights of investable securities, daily pricing, and relatively low turnover. Historical data should also be readily assessable, and the securities should be specified in advance so that it is possible for market participants to estimate expected returns and calculate relevant risk characteristics.

The divergent performances of indices this year is a stark reminder that not all market benchmarks are created equally, and the choice of benchmark can have a material impact on your portfolio performance and draw down risk. Ultimately investors are looking for consistent positive returns, not to outperform some arbitrary benchmark which may not meet their long-term goals.

One of the challenges of market capitalisation weighted benchmarks is that the concentration in a few large companies can undermine the objective of being representative. Concentration has been quietly increasing in most equity benchmarks over recent years and challenging the diversification benefits.

Behemoths like Apple, which accounts for 7% of the US S&P500 index and almost 5% of MSCI World Index, can have an outsized impact on index returns. Today, the ten largest names in the S&P 500 index make up nearly 28% of its market capitalisation, up from 18% five years ago. In the MSCI Emerging Markets Index, the top ten names of the nearly 1,400 companies included in the index accounts for 22% of the index market capitalisation.

Closer to home, BHP now represents over 10% of ASX200 index simply because the dual listing structure following the Billiton merger has now been collapsed and the entire share capital now resides in Australia. If an investor was looking for a portfolio representative of Australian economic activity, the BHP weight is a massive distortion.

Concentration concerns are not limited to equity markets. Bond indexes using market-cap weighting can have a troubling twist: The largest weights are given to those with the biggest debt loads, which can be a sign of deteriorating finances at both the country and company level.

When an investor examines their portfolio, they need to be aware of the concentration risks in the underlying benchmarks along with the temptation of investment firms to simply take on more risk to beat the benchmark. This can take the form of outsized investment positions or even choosing securities from outside the benchmark universe. Concentrated portfolios increase the idiosyncratic risk that a surprise one off event can seriously undermine investment performance.

With benchmarks today covering all types of regions, asset classes and investment opportunities, investors should carefully consider the underlying embedded risks and drawdown characteristics of what they own. What is the worst decile of returns you can expect from investing in this basket of securities? Concentration risk will play a significant part in those calculations along with where securities are in fact generating their financial returns. Do not forget that the US market only accounts for about 40 per cent of Apple’s sales. And do not assume that capitalisation-weighted benchmarks are well-diversified portfolios. Sometimes it will pay to take a more active portfolio approach by reducing large name exposures to better diversify idiosyncratic, sector, and country risk.

What an investor should be doing is analysing every investment opportunity on its merits and assessing how it impacts the risk return characteristics of the entire portfolio. All investment opportunities should in effect be in competition with each other for capital in a portfolio all the time.