Elston supports UK financial advisers CIP/CRP/MPS
  • WHO WE ARE
    • About
    • Our Journey
  • WHAT WE DO
    • Elston Portfolios >
      • Our Portfolios
      • Adaptive Portfolios
      • Retirement Portfolios
      • Sustainable Portfolios
      • Multi-Asset Income
      • All Weather Portfolio UK
      • Money Market Portfolio
    • Custom Portfolios >
      • Custom Portfolios
    • CGT Solutions >
      • Our CGT Solutions
      • GIA Portfolios
      • Onshore Bonds
      • Direct Gilts
    • Adviser Support >
      • Our Adviser Support
      • CIRP
      • Investment Committee Support
      • Regulatory Support
      • Analytics, Factsheets & Reporting
      • CPD
    • Fund Solutions >
      • Our Funds
      • Custom Funds
    • Index Solutions >
      • Our Indices
      • Sector Equal Weight
      • UK Equity Income
      • Liquid Real Assets
      • Gold and Precious Metals
      • Custom Indices
  • WHO WE HELP
    • Financial Advisers
    • Discretionary Managers
  • Insights
  • Contact

Asset Allocation Research for UK Advisers

Fed up with cap-weighted indexes? Then don’t use them

12/1/2021

 
Picture
[5 min read, open as pdf]

  • Tech performance is skewing cap-weighted indices
  • Increased concentration reduces diversification
  • Using cap-weighted indices is an active choice
 
Tech performance is skewing cap-weighted indices
The run up in technology stocks and the inclusion of Tesla into the S&P500 has increased both sector concentration and security concentration.  The Top 10 has typically represented approximately 20% of the index, it now represents 27.4%. 
The chart below shows the Top 10 holdings weight over time.
Picture
Picture
​Rather than looking just at Risk vs Return, we also look at Beta vs Correlation to see to what extent each strategy has 1) not only reduced Beta relative to the market, but also 2) reduced Correlation (an indication of true diversification).  Strategies with lower Correlation have greater diversification effect from a portfolio construction perspective.
Ironically, the last time the index was anything close to being this concentrated was back in 1980 when IBM, AT&T and the big oil majors ruled the roost.

From a sector perspective, as at end December 2020, Information Technology now makes up 27.6% of the index.

Increased concentration reduces diversification
This level of concentration is indeed skewing indices that rely on a traditional market capitalisation-weighted (cap-weighted) methodology, and does therefore reduce diversification.
But the issue of the best performing stocks getting a larger weighting in the index, is not an accident of traditional index design.  It’s its very core.  Cap-weighted indices reflect the value placed on securities by investors, not the other way round.

We should not therefore conflate the debate around “active vs passive” investment approaches, with the debate around index methodology.

If portfolio managers are concerned about over-exposure to particular company or sector within a cap-weighted index, they can either chose an active, non-index fund, that is not a closet-tracker.  Or they can access the target asset class through an alternatively weighted index, which uses a security weighting scheme other than market capitalisation.

Using cap-weighted indices is an active choice
The decision to use a fund that tracks an cap-weighted index is an active choice.  And for those seeking differentiated exposure, there is a vast range of options available.

We categorise these into 3 sub-groups: Style, Factor-based and Risk-based.
  1. Style-based: for example: Value, Growth, Income.  This is the classical style-based approach.  Value investing traces back to Graham & Dodd’s research in the 1930s.
  2. Factor-based: for example: Value, Size, & Quality.  Factor-based investing weights securities by their internal fundamental characteristicss that relate to their expected drivers of returns: for example securities included in a Quality index would be included based on profitability and/or Return on Equity metrics.  Min Volatility (lowest and Momentum relate to the performance of the security rather than its fundamentals.  Our recent CPD webinar explores factor-based investing in more detail.
  3. Risk-based: probably the least developed area.  Risk-based investing weights securities by their relationship to each other in order to target a particular target risk characteristic.  Examples include: Max Deconcentration (aka Equal weighted); Max Diversification; Max Decorrelation; Max Sharpe; Min Variance, Risk Parity (aka Equal Risk Contribution) and Managed Risk.  Our recent CPD webinar explores risk-based investing in more detail.
  4. Min Volatility or Min Variance? What’s the difference? Semantics, but for differentiation, we refer to Min Volatility when a strategy ranks securities by their volatility, to include only those lowest volatility stocks (hence used when referring to Factor-based strategies).  We refer to Min Variance when a strategy looks at risk and correlation structure between stocks to target a “minimum variance portfolio” of those securities (hence used when referring to Risk-based strategies).  So similar, but different.
With that array of index methodologies for US equities to choose from, there’s no excuse for complaining about being fed-up with the traditional cap-weighted approach.  Index selection, depends, of course, on portfolio construction objectives, and index methodology due diligence remains key.

How have US equity risk-based strategies fared?
Risk-based strategies have been in existence for some time, so we are able now to consider 10 year data (to December 2020, in USD terms).  In terms of risk-adjusted performance, Managed Risk index strategies have fared best, whilst Min Variance has delivered higher returns for similar levels of risk of a Max Diversification strategy.  Meanwhile Equal Weight has actually exhibited greater risk than traditional cap-weighted approach.
Picture
In this respect, Equal Weight (Max Deconcentration), also disappoints delivering higher beta and >95% correlation.  Likewise Min Variance, whilst delivering on Beta reduction, does not deliver on decorrelation.  Max Diversification delivers somewhat on decorrelating the strategy from the S&P500, but only modestly, whilst Managed Risk achieves similar decorrelation, reduced beta and better returns.  Finally Risk Parity 10% Volatility cap has delivered most decorrelation as well as beta reduction.
For more information about the indices and funds used to represent these different strategies, please contact us.
​
Summary
There are a broad range of alternatives to cap-weighted index exposures.  But consideration of style-, factor- or risk-based objectives will necessarily inform portfolio construction.
  • Fiscal and policy support should keep growth shock short and sharp
  • Inflation looks bottled – for now, but this is the key focus
  • Asset price recovery was welcome but vigilance now required
 
Find out more
For more insights and information on research, portfolios and indices, visit:
www.elstonsolutions.co.uk or NH ETF<Go>

Comments are closed.

    ELSTON RESEARCH

    insights inform solutions

    Get our weekly newsletter

    Categories

    All
    All Weather Portfolio
    Alternative Assets
    Alternative Strategies
    Bonds
    Business Practice
    Capital Market Assumptions
    CPD
    Direct Gilts
    Equities
    Equity Income
    Equity Sectors
    ESG
    ETFs
    Evidence Based Investing
    Factor Investing
    Geopolitics
    Gold & Precious Metals
    Guide To Investing
    Index Investing
    Inflation
    Investment Trusts
    Macro
    MULTI ASSET
    Multi Asset Income
    Net Zero
    Outlook
    Permanent Portfolio
    Podcast
    Portfolio Construction
    Private Markets
    Real Assets
    Retirement Investing
    Risk Parity
    Thematic Investing
    Value Factor
    Video

    Archives

    June 2025
    May 2025
    April 2025
    March 2025
    February 2025
    January 2025
    December 2024
    November 2024
    October 2024
    September 2024
    August 2024
    July 2024
    June 2024
    May 2024
    April 2024
    March 2024
    February 2024
    January 2024
    December 2023
    November 2023
    October 2023
    September 2023
    August 2023
    July 2023
    June 2023
    May 2023
    April 2023
    March 2023
    February 2023
    January 2023
    December 2022
    November 2022
    October 2022
    September 2022
    August 2022
    July 2022
    June 2022
    May 2022
    April 2022
    March 2022
    February 2022
    January 2022
    December 2021
    November 2021
    October 2021
    September 2021
    August 2021
    July 2021
    June 2021
    May 2021
    April 2021
    March 2021
    February 2021
    January 2021
    December 2020
    November 2020
    October 2020
    September 2020
    August 2020
    July 2020
    June 2020
    May 2020
    April 2020
    March 2020
    February 2020
    January 2020
    December 2019
    November 2019
    September 2019
    June 2019
    April 2019
    March 2019
    February 2019
    January 2019
    December 2018
    November 2018
    October 2018
    September 2018
    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    July 2017
    May 2017
    March 2017
    February 2017
    January 2017
    November 2016
    October 2016
    September 2016
    July 2016
    June 2016
    May 2016
    February 2016
    January 2016
    August 2015
    June 2015
    January 2014
    June 2012

    RSS Feed

Company
Home
About
​Our Journey
​​​Contact
Terms of Use
​Our Solutions
​​Insights
​Our Portfolios
Custom Portfolios
​Retirement Portfolios
Our CGT Solutions
Our Funds
Custom Funds
Our Indices
Custom Indices
​Adviser Support
CIRP
Investment Committee Support
Regulatory Support
Analytics, Factsheets & Reporting
CPD


By client type:
For Advisers
For Discretionary Managers


© COPYRIGHT 2012-25. ALL RIGHTS RESERVED.
 Elston Consulting Limited (Company Registration Number 07125478) is registered in
England & Wales, Registered address:  1 King William Street, London EC4N 7AF
  • WHO WE ARE
    • About
    • Our Journey
  • WHAT WE DO
    • Elston Portfolios >
      • Our Portfolios
      • Adaptive Portfolios
      • Retirement Portfolios
      • Sustainable Portfolios
      • Multi-Asset Income
      • All Weather Portfolio UK
      • Money Market Portfolio
    • Custom Portfolios >
      • Custom Portfolios
    • CGT Solutions >
      • Our CGT Solutions
      • GIA Portfolios
      • Onshore Bonds
      • Direct Gilts
    • Adviser Support >
      • Our Adviser Support
      • CIRP
      • Investment Committee Support
      • Regulatory Support
      • Analytics, Factsheets & Reporting
      • CPD
    • Fund Solutions >
      • Our Funds
      • Custom Funds
    • Index Solutions >
      • Our Indices
      • Sector Equal Weight
      • UK Equity Income
      • Liquid Real Assets
      • Gold and Precious Metals
      • Custom Indices
  • WHO WE HELP
    • Financial Advisers
    • Discretionary Managers
  • Insights
  • Contact