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April 23, 2020

Kevin Karpuk CFA

“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business.” - Gary Cohn
We have written before about the risks to passive investors when indexes become very concentrated. As that article points out, the lack of diversification causes pain when the largest constituents in the index fall back to earth. The following is my imagined conversation that may have happened in a lot of consulting shops over the past decade.
 
Analyst 1: “Ugh, most of our active large cap growth managers are getting crushed by the index. Again.”
 
Analyst 2: “Want me to find you a manager with more than 30% of its portfolio in four holdings? How would our investment committee or clients like that?”
 
Analyst 1: “Right. I almost forgot that Microsoft was nearly 10% of the Russell 1000 Growth, Apple is 8%, Amazon is close to 6%, and Alphabet (Google) is over 5%.
1
 
Analyst 2: “Yep. The FAAMGs
2 strike again.”
 
The Russell 1000 Growth Index has been a juggernaut, performing in the top 15th percentile against active managers in the space over the past decade[3]. During this time, the FAAMGs have become an ever-larger part of the index as their market dominance has increased.
 
When looking at a portfolio (or treating an index as a portfolio), there are various measures of concentration risk. One such measure is Issue Diversification which measures how many stocks make up 50% of a portfolio. In the chart below, you can see that the largest 52 stocks compose 50% of the Russell 1000 Value Index whereas only 24 stocks account for half of the weighting of the Russell 1000 Growth Index.



Noticeably to us, the Value Index has been much more stable in terms of diversification whereas the Growth Index has had larger swings and is currently approaching 30-year lows by this measure. What this says to us is that there may be risks that investors in passive products are taking that they may not be aware of. As a matter of fact, the last time the index was so concentrated was during the Tech Bubble of the late 1990s. In 2000, during the initial phase of the market meltdown, the index underperformed 82% of active managers4.
 
We are not suggesting that these large tech companies are facing imminent doom. In fact, Microsoft and Amazon have shown their durability during the COVID-19 shutdown. What we are saying is that they do have lofty expectations and potential anti-trust issues staring at them. Investors need to understand that they may not be as diversified as they think they are.
 
Stay safe and healthy. Please do not hesitate to reach out to us with questions or comments. We look forward to seeing you all soon!
 
1 As of 04/20/2020, Frank Russell
2 Facebook, Amazon, Apple, Microsoft and Alphabet (nee Google)
3 Through 12/31/2019 compared to the Callan Associates, Inc. Large Cap Growth Mutual Fund Universe
4 Ibid
 

Kevin Karpuk, CFA Chief Investment Officer

Kevin is Cornerstone’s Chief Investment Officer and is involved with the firm’s Investment Policy and Strategic Planning committees. Kevin joined the company in 2000 after graduating from Lehigh University with a B.S. and M.S. in Economics and earned his CFA charter in 2005. Kevin and his wife Kat support many charitable causes and have established a donor advised fund to propagate their philanthropic interests. They live in Bethlehem with their two cats: Zola and Charlyne, enjoy woodworking, gardening, reading and travel. Kevin is the proud uncle to many nieces and nephews and loves spending time with and spoiling them.

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