Back then, Nokia accounted for a mind-boggling 70 per cent of the exchange’s total market capitalisation. The company had become the global leader in the mobile phone market, boosting its share price 30-fold in just six years. Off a high base, the price had trebled in the last year.
It didn’t last, of course. Nokia immediately gave back those 12-month gains when the tech bubble burst, and even more when it missed the move to smartphones and got carried out by Apple and Android. Long story short, the share price lost 95% peak to trough (2000 to 2012).
Fortunately, no such market-cap-weighted index fund existed in 2000, or even today. The first tracker on the Helsinki exchange launched in 2006, and it shadows the benchmark OMX Helsinki 25 index, which sensibly caps exposure per share at 10%.
Still, fictional or not, it makes for a good argument against index tracking. No right-minded active manager would ever assume this kind of concentration risk, hitching 70% of their portfolio to the fortunes of just one company.
It’s an argument that is gaining traction locally, because our most popular benchmark index, the FTSE/JSE Top 40, is not capped and now presents Nokia-type concentration risk for the unwary.
The culprit is Naspers, the once sleepy publishing house that now dominates the JSE on the back of its fortuitous investment in Tencent, the Chinese media company. Naspers already looked prohibitively expensive at the beginning of the year, but put on another 80% anyway. It now accounts for more than 20% of the FTSE/JSE All Share Index by market cap.
As the Top 40 index trackers hold just the 40 largest companies on the JSE, they are even more exposed to Naspers. Their mandate compels them to maintain a full weighting, but no responsible portfolio manager would do so. It subjects investors to so much unsystematic (stock-specific) risk that it crosses the line from investing to speculation.
Everyone’s favourite benchmark index in the US, the S&P500, does not have this problem. The top four shares – Apple (3.95%), Microsoft (2.90%), Amazon (2%) and Facebook (1.93%) – make up less than 11%.
Concentration risk
The concentration risk in our market feeds the industry narrative on the perils of indexing, or “mindlessly following the benchmark” in South Africa. The critics argue that this proves that indexing may be suitable for the US, but not South Africa.
We agree, in part. Tracking a market-cap-weighted index might be the purest form of passive investing, but it is not always the most sensible. It can defeat the very purpose of this investment style: eliminating unrewarded risks.
Investors should only assume risks that promise a higher return. Investing in the stock market is such a risk because, despite short-term volatility, this asset class habitually delivers the best long-term returns.
Fund manager selection, on the other hand, is not. Logically, all fund managers cannot deliver an above-average return. Empirically, only a minority do, even before fees. And no one knows who it will be. Your chosen fund may beat the index, but probably it won’t. Index funds minimise your risk of underperformance.
High fees are not rewarded either. The adage “you get what you pay for” is bogus when it comes to investing – higher fees do not mean a higher return. Usually, the opposite is true. Expensive funds tend to deliver worse returns, and are less likely to survive than cheaper alternatives. Again, you can avoid this risk with a low-cost index fund.
Avoid over-exposure
Concentration risk also falls into this category. A diversified portfolio will avoid over-exposure to the price moves of one, or even a basket of investments. Such spreading encompasses securities, sectors, asset classes, currencies, geographies, any factors not strongly correlated in their reaction to market developments. Coupled with disciplined rebalancing, a well-diversified portfolio will, on average, yield a higher return, with less volatility than a concentrated portfolio.
When tracking a broad market index, investors expect to be adequately diversified and not assume concentration risk. But that’s not the case with the JSE, which means a market-cap-weighted indexing strategy is simply not appropriate.
There are no hard and fast rules on concentration limits. Regulation 28 of the Pension Funds Act puts it at 15% per share. Capped indices tend to apply a 10% limit. That’s still high if your entire portfolio is invested in just one benchmark index, but that itself would be imprudent. Most investors spread their money across different asset classes which usually halves their exposure to any one share.
Broader universe
The 10X SA Equity index takes a more prudent view still. Rather than limit the investment universe to 40 shares, it holds the top 60 shares, individually capped at 6% at the time of re-weighting. The broader universe and the 6% cap improve diversification; the proprietary nature of the index protects investors against price distortions around the time we reconstitute the index.
In the context of their overall portfolio, our investors thus rarely have exposure to any individual shares above 4%. That counts against us when a mammoth like Naspers is doing so well. It will be near impossible for any manager to match the return of a Top 40 index fund this year.
But that’s okay. It’s not our ambition to deliver the highest annual return. The more relevant issue is: which indexing strategy is more risk-appropriate for long-term investors? We like to believe it is the one that eliminates all unrewarded risks, not just two out of three.
Read more about 10X's investment strategy here.
