Australian shares have recently delivered robust returns: in the year to 31December 2013, the S&P/ASX200 Accumulation Index returned 20.2 per cent.
However, a closer look at where this performance came from gives cause for concern. Far from being a broadly-based market rally, this return outcome was actually very narrowly based.
A few stocks have done the heavy lifting
The performance of just five stocks (Commonwealth Bank, ANZ, National Australia Bank, Westpac, Telstra), which were the preferred investments of yield-seeking investors, together accounted for 54.9 per cent of the Australian share market’s return in 2013.
And this isn’t a new phenomenon: in the decade to 2010, the banks and BHP Billiton accounted for 51 per cent of the return of the S&P/ASX200 index.
The concentration of the market’s return among just a few stocks is one more sign that Australia’s share market is too concentrated. Australian investors who choose a high exposure to Australian shares may find that over time, they become far too reliant on only a few companies for returns. While that may not be of concern if those companies are performing well in share price terms, there is always the risk they may not.
Creating a high level of Australian stock-specific risk in a supposedly diversified portfolio isn’t hard to do. Together, the big four banks in the S&P/ASX200 index are now 29.5 per cent of the index, up from just 16 per cent at the beginning of 2001. The ten largest companies by market capitalisation now account for 55.3 per centof index value and the top 20 companies’ share of index value is 66.5 per cent.
A “diversified” portfolio can be surprisingly concentrated
Here’s how an investor can build a “diversified” portfolio that results in significant and perhaps unintended Australian stock-specific risk. Let’s say they have a portfolio of 40 per cent in Australian shares, 25 per cent global shares, 5 per cent Australian REITs and 30 per cent bonds. The client has opted to have their investments managed on an index basis. Below are the largest stock holdings that result from this asset allocation, based on the index weights of each company at 31 December 2013.
• Commonwealth Bank: 3.8 per cent
• BHP Billiton: 3.6 per cent
• Westpac: 3.0 per cent
• ANZ Bank: 2.6 per cent
• NAB: 2.4 per cent
• Telstra: 2.0 per cent
• Apple: 0.3 per cent
• Exxon: 0.3 per cent
By biasing the portfolio towards a concentrated share market like Australia’s, this investor has created a portfolio that is poorly diversified, and has considerable stock-specific risk. Over 15 per cent of the portfolio value is in five companies, four of them (banks) in the same industry. Exposure to each of the world’s two largest companies, Apple and Exxon, is just 0.3 per cent.
This portfolio is very vulnerable to unexpected events that may be adverse to the Australian economy, particular industry sectors and specific companies that dominate the stock market. If Australia’s economy slowed, it could impact company earnings and possibly dividends. Developments overseas could also impact Australia, with a slowdown in China’s economy the most obvious.
Restricted choice also limits diversification
The Australian share market’s structure complicates the task of building a well-diversified portfolio. This is because there is limited investment choice in many industry sectors. For example, information technology is a growth sector globally, yet there are only five companies to choose from in the Australian Information Technology sector, which accounts for just 0.8 per cent of our market’s value. Compare this to a global shares index, like the MSCI All Countries World Index, in which the Information Technology sector accounts for 12.1 per cent of the index and has over 220 companies.
Doubling up with direct shares
If the investments in the sample portfolio above are made through a managed fund, some investors could accentuate these stock-specific exposures by also owning Australian shares directly. This increases the stock-specific risk and dependence on them for returns.
Weighing up the reasons for investing in Australian shares
There are many valid reasons for having a meaningful exposure to Australian shares. Some Australian companies’ dividends provide a useful source of income and tax franking credits, and the long-term returns of Australian shares have been competitive against other investments.
Some investors may tolerate the stock-specific risk that may exist in their portfolio. But for those who want more certainty about their long-term wealth creation outcome, there are many investment opportunities – such as global shares, alternatives, hedge funds, multi-asset class strategies and bonds–available through managed funds that can moderate these risks and provide additional sources of return.
