A smarter way to address concentration risk

Paul: [00:01] Welcome to Index Ideas from FTSE Russell I'm Paul Amery, your podcast host. In the podcast, we explore index ideas that can help address real-world investment themes and challenges. The concepts that we discuss in the podcast are not investment advice. They represent transparent, systematic approaches that may be developed into indices and made available for broad public use. Any reference to potential strategies is intended for informational and educational purposes only. In this episode, I'm joined by Sebastian Lancetti, who is Head of Index Research and Design Americas at FTSE Russell. Sebastian is here to talk about one of the hottest topics in global equity markets: concentration risk and how to address it. Sebastian how concentrated are the US and global equity markets?

Sebastian : [00:48] Markets are extremely concentrated. In fact, we are at all-time highs in terms of concentration. That is especially the case in the United States in the Russell 1000 index (in the large cap space in the United States). But we see the same phenomenon across all global markets.

Paul: [01:08] So why is concentration risk a concern for investors?

Sebastian : [01:09] Well, several things.

First of all, as markets become more and more concentrated, a lot of the risk is really down to idiosyncratic risk--the risk associated with just very few names. If you think about the “Magnificent Seven” in the United States, anything that happens to those big names will have a large impact on any portfolio that's benchmarked to the most common US equity benchmarks.

Another important aspect is it's not just a risk associated with very large names, but it's also the potential for performance: as more and more of the returns are driven by fewer names, the potential for outsized or large performance in the future is reduced when concentration is as high as it is today.

Paul: [01:53] What typically happens when we have periods of very high index concentration like at present?

Sebastian : [01:59] High levels of concentration can persist for a very long time. But typically, if we look at historical patterns, we see mean reversion. It's quite common for markets that are very, very concentrated to mean revert. That is, when you see the level of concentration we see in the current equity market, it tends to be better to diversify away. Historically, allocating, for example, to a Russell 1000 equal-weighted index would have resulted in better returns over the coming 5 to 10 years, following periods of high concentration.

Paul: [02:33] So could you run us through some of the different ways of building a more diversified equity index?

Sebastian : [02:40] Yes, the first and most obvious way to diversify an index is simply to go equal weighted. That is the approach followed by a lot of investors, especially retail investors, they would just shift from a cap-weighted index to an equal-weighted index. We have alternatives to that. Another approach, which is used a lot, especially for regulatory requirements, is to put caps on this weight of individual names. So this capping approach is another way to reduce concentration in an index. We do think, however, that both capping and especially equal-weighted solutions are not the right choice for the vast majority of investors.

Paul: [03:22] What is FTSE Russell's target diversification approach?

Sebastian : [03:36] Our new flagship methodology tries to give investors a right trade-off between concentration risk, on the one end, and market representativeness on the other end. The FTSE Russell Target Diversification approach is composed of two key elements. The first one is really quantifying the level of concentration using a straightforward non-model-driven approach. So we look at the market and quantify the level of concentration. I'll elaborate a little bit later on how we do that. But the second key component is when to redistribute the weights in a benchmark as to improve the level of diversification, but at the same time without creating too many distortions when doing so.

Paul: [04:15] So why has Russell introduced this approach? Was it as a request from clients? Was it something we developed internally? How did this index idea come about?

Sebastian: [04:23] Well, due to the unprecedented level of concentration in the market, we have a lot of issues as investors when it comes to allocating to even very broad indices, such as the Russell 1000. So, there is a need in the market to be able to keep market representativeness and have an index that represents what the opportunity set truly is, but at the same time reducing the level of concentration.

There are investment-related concerns: simply, the idiosyncratic risk we mentioned earlier, but also the dependency of performance on just a few names. So those are clearly very, very important aspects of why concentration is problematic. But there are also regulatory requirements that force investors to be more diversified. And therefore we think that in this current market, it is very, very important to find methodologies that can reduce the level of concentration in the market, but methodologies that can also do this efficiently without all the distortions and the problems associated with more traditional approaches, such as equal weighting.

Paul: [05:36] Sebastian, you mentioned that there are two elements to the target diversification methodology. One is the diversification factor and the other is how we scale the index weights. Could you explain those in turn? What's the diversification factor?

Sebastian : [05:48] Yes. So first of all we need to have a clear, simple, transparent, highly tractable way of measuring concentration. So the FTSE Russell diversification factor just expresses the concentration in the market by comparing the market cap-weighted index with the number of equivalent stocks in an equal-weighted index.

For example, if we look at the Russell 1000 today. As the name implies, we have around 1000 names in the index. But if we look at the weights within the index, because of the extreme concentration, we're actually looking at an index that is very close to an equal-weighted index with just 60 names. So the FTSE Russell target diversification factor just expresses the number of equivalent stocks when we compare a cap-weighted index to an equal-weighted index. Another example--if you were to look at the FTSE Developed index, we start with roughly 2000 names in the index. But the FTSE Russell target diversification factor implies that the FTSE Developed index is very, very similar to an equal-weighted index with just 100 names. So that's how we decided to quantify the level of concentration, because we believe that it's highly tractable. It makes intuitive sense, but it's still a very powerful way to track and monitor levels of concentration across indices.

Paul: [07:17] So, once we've, let's take the Russell 1000 example and you say that it currently has a diversification factor of about 60. Let's say we want to change that to 200. How do we rescale the index weights to achieve that?

Sebastian : [07:29] Yes. First and foremost it's defining what's the diversification factor we really want. So in your example we are going for 200 names. So what the methodology does. The second part of the methodology is the algorithm that allows us to go from 60 to 200. That essentially means we need to take some weight away from the very large names and redistribute it across the smaller names.

Where our methodology differs from other approaches is that the algorithm that allows us to do so does it in a non-linear way, and it has been developed to minimise distortions in terms of changes related to industry weights, but also investment styles, attributes of indices. So our approach maintains liquidity, maintains capacity when we look at large allocations to indices and tries to minimise distortion related to, again, factor exposures or industry exposures or country exposures in a global index. All that without needing factor models, covariance matrices or anything like that. Which makes the methodology very, very robust, intuitive and tractable.

Paul: [08:50] So to which equity indices are we applying this approach currently?

Sebastian : [08:54] Currently we are applying this approach in the US large cap space in the Russell 1000. Because of the names that are driving the extreme level of concentration these days. A lot of those names are growth companies. We also apply this methodology to the Russell 1000 Growth index, where the level of concentration is truly extreme. So there it's really, really imperative to do something about concentration. But the same is also true when we look across geographical regions. And so another application is starting with the FTSE Developed index. And we aim to reduce the level of concentration of that index to make it again more diversified for sure, but also to reduce indirectly the weight of the United States, which has reached very, very extreme levels: roughly 70% of the FTSE Developed index today is composed of US stocks. So our approach in the FTSE Developed index is to target a level of diversification of 400, which would essentially bring back the level of concentration to what it has been historically, and also address concerns that a lot of investors have these days about an overallocation to the US market, specifically an overallocation to US technology companies.

Paul: [10:15] Thank you Sebastian. Finally, where can listeners to this podcast find out more about target diversification and how it works?

Sebastian : [10:22] Well, first and foremost in our blog. So, of course, we will publish summaries and updates through our blog. We also have research papers, and of course we welcome calls, and we are always happy to answer any specific questions our clients have.

Paul: [10:41] Thank you Sebastian. And that's it for this episode. If you've enjoyed the conversation, then please do follow us and give us a positive rating or review on your podcast app of choice. And if you'd like to get in touch with the show, you can do that via the email fmt@lseg.com. But for now from me, Paul Amery, goodbye.