Diversification is one of the most effective methods of mitigating investment risk. Although such an approach might dilute the amount of profit you make from your winning choices, it also acts to mitigate the losses from those that fail. Most investors aim to achieve a fairly steady return on their capital over time, so a good spread of investments is essential in order to smooth out the inevitable volatility and reduce the prospect of permanent loss.
However, if diversification is the objective, it is important to understand just how much diversification you are achieving. Your investments might in reality be a lot less diversified than you think, particularly if they are focused on UK stock market indices or collective investment funds that use those indices as a benchmark.
Unlike most other stock markets, the UK stock market is dominated by a small number of colossal companies. Most stock market indices are weighted, so the performance of these companies acts to distort the performance of the UK stock market as a whole. To put this into perspective, the 10 largest companies (by market capitalisation) in the FTSE 100 Index represent 47% of the Index. In contrast, the 10 smallest companies (by market capitalisation) in the FTSE 100 Index represent just over 1% of the Index.
Therefore, although you might feel that your investments are well diversified across 100 companies if you are invested in a FTSE 100 based fund, the reality is very different. If the share price of the largest company (currently Royal Dutch Shell) fell by 10% the share price of the smallest company (currently ENRC) would need to increase by 2700% to compensate.
Many investors believe this problem is alleviated by investing in funds that are benchmarked to the FTSE All-Share Index. However, the All-Share Index does not actually represent all shares. Of the thousands of quoted companies listed in the UK, the shares of only 630 companies are currently eligible to be a constituent of the Index. As a consequence, the diversification benefit of the FTSE All-Share Index over the FTSE 100 Share Index is marginal. For example, if you invested in the FTSE 100 Share Index, 8.54% of your money would in effect be invested in the shares of Royal Dutch Shell. Investing in the FTSE All-Share Index as an alternative would dilute your exposure, but only to 7.63%.
To illustrate just how skewed the FTSE All-Share Index is (in favour of a relatively small number of large companies) consider the S&P 500 Index, which tracks 500 of the largest companies quoted in the US. The largest company (currently Apple) accounts for 2.97% of the index and the 10 largest companies currently account for only 18.5%. This is a much more diversified and as a consequence less risky investment allocation.
Returning to the UK stock market, although the skew of the FTSE All-Share Index is large in relation to the value of companies, it is even larger when one considers the concentration of dividends.
It is hard to believe but 38% of all dividends paid by the FTSE All-Share Index companies (of which there are 630) can be attributed to just 5 companies and the top 20 companies account for roughly two thirds of all dividends paid. This is partly explained by the fact that larger companies tend to be mature and having passed through the stage in their lifecycle where the highest levels of growth are achieved, typically pay investors a generous level of dividend to compensate for the limited growth potential.
As a consequence, the share price is often underpinned by the level of the dividend and is vulnerable to fall if it is cut. This vulnerability is probably greater than we would normally expect because the share prices of such companies have been driven high by investors rotating out of the bond market (selling fixed interest investments to protect against future losses when interest rates rise and investing in the shares of big dividend paying companies to replace cash flow). In fact, some believe there might be a bubble in this area of investment.
It is also worrying that many of the big dividend paying UK companies would appear to have limited opportunity to grow their revenues and might therefore struggle to maintain the current level of dividend payment as their costs rise.
You might be wondering how investment strategies should be adjusted to reflect the above. In order to reduce ‘concentration’ risk, client portfolios in PMW’s Wealth Management Service most often use actively managed funds that do not benchmark to the FTSE All-Share Index to invest in UK companies. Also, at this stage in the recovery cycle, there is merit in looking at medium sized dividend paying companies that demonstrate earnings growth and have strong balance sheets. The first rule of investment is to understand what you are buying. If you are buying shares in a wide range of companies, you are effectively buying an assortment of future cash flows (dividends). Your prospect of a capital gain, as well as income, is enhanced if the future cash flow turns out to be greater than first anticipated. Selecting investment managers that are capable of both picking winners and delivering diversification requires careful analysis. A good reason for you to seek some sound advice…