Do index fund returns depend upon just a few stocks (Concentration risk)?

Published: July 18, 2020 at 11:52 am

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Take the NIfty 50 index. It has 50 stocks and that sounds like a lot, but just ten of then make 62.7% of the total weight.  In the case of the Sensex, it is 71.11%. Even in the case of the S&P 500 the top 10 accounts for 27.1% of the total weight (all nos as of June 2020). This automatically leads to the question if index funds (at least the market-cap-weighted ones) suffer from concentration risk compared to active diversified funds. That is, do their returns and risk depend on the fortunes of just a few stocks? Is this the price of low-cost investing?

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A simples illustration of market depth – or how easy it is to sell stocks in bulk during a crisis – is a comparison of the NIfty 500 (which 100 large cap + 150 mid cap + 250 small cap stocks) vs the S&P 500 (500 large caps).

The top ten stocks of the NIfty 500 make up 43.72% of the total weight a good 1.6 times the corresponding number (as above) for the S&P 500. Another way to study market depth is the impact cost (mismatch between buying and selling price when the quantity is large): Warning! Even large cap stocks are not liquid enough! Can you handle this? This is the reason why even the Nifty Next 50 (technically large cap as per SEBI) has a risk comparable to Midcap stocks: Warning! Nifty Next 50 is NOT a large cap index!

Before we go on to check if actively managed diversified large cap funds are any better than index funds in this regard, let us consider, what is wrong with concentration risk?

If just a handful of stocks make up most of the stock portfolio then their fortunes determine the portfolios. If any of the big names get into trouble – fraud, insider trading etc – then the index could correct sharply. It may take months before such stocks are weeded out of the index.

When put this way, active funds sound better, seem better. Sadly this does not translate into hard data. Many people believe the “popularity of index funds” is a recent phenomenon caused by an imbalance discussed here: Is this market rally bad for equity mutual funds (active/passive)?

This is not true. Even before the onset of this imbalance (Feb 2018), active large cap funds have struggled: Poor performance of active mutual funds: Is this a recent development?

With this background let us investigate the weight of top-ten stocks in active large cap portfolios. The weight of the top ten stocks (excluding cash or overnight bonds if it is part of the top 10); cash holding; the number of stocks in the top ten that differ from the index and the total number of securities are tabulated below.

FundWeight of Top 10 stocks (excl cash)Weight of cash or overnight bonds (if in top ten)No of stocks in top 10 different from Nifty/SensexTotal no of securities incl cash
HDFC Index Fund-Sensex71.11%32
HDFC Index Fund-NIFTY 50 Plan62.70%52
HSBC Large Cap Equity Fund62.30%129
Axis Bluechip Fund61.50%11.60%229
Franklin India Bluechip Fund61.10%9.10%727
Essel Large Cap Equity Fund59.70%248
HDFC Top 100 Fund55.80%456
BNP Paribas Large Cap Fund53.30%5.59%236
Mirae Asset Large Cap Fund51.74%262
Kotak Bluechip Fund51.10%158
Aditya Birla SL Frontline Equity Fund50.50%267
DSP Top 100 Equity Fund50.30%6.15%338
Baroda Large Cap Fund50.10%6.80%238
ICICI Pru Bluechip Fund49.75%3.70%373
Canara Rob Bluechip Equity Fund49.20%5.39%143
SBI Bluechip Fund43.90%3.75%461
Edelweiss Large Cap Fund34.60%26.10%468

While it is true that actively managed large cap funds typically reduce concentration risk by 15-20%, most of the stocks in the top ten holdings are identical to the index as of June 2020. Therefore passive fans need not lose sleep over this.

While this may be a constant feature, since we have not looked at holding-history, we will have to give the benefit of doubt to active funds – that they are simply holding more of the stocks that are driving the market up.

A passive fan may argue the reduction in concentration risk is not significant and the return drivers in an active fund are similar to a passive fund. The active fund investor, if not convinced about shifting to passive funds, must keep track of the number mentioned above to find out the benefits of the extra expense ratio. At the very least, is active management lowering concentration risk and volatility significantly?

Another argument that passive fans can put forth is, if any of the big wigs get into trouble, they would drag the entire market down and so active management (which not quite active anyway) will not help much.

A stock with high index-weight has more liquidity and low impact cost. This is why stocks like HDFC Bank can be found even in small cap funds. It is almost a substitute for cash and in and outflows can be handled well. So to some extent, it is justifiable that the top couple of holdings of an active fund is identical to the index. However, what is seen above is a bit too much although we need to dig deeper into the past/future to be conclusive.

To summarise, passive investors need not be overly worried about concentration risk. It exists in active funds too. Active investors have a few things to ponder!

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