Passive investing continues to grow rapidly in Australia, reflecting a growing emphasis on lower cost ways to gain exposure to the sharemarket. While passive investing may appear to offer a sensible way to broaden market exposure, it comes with risks. One of the most significant current risks is that the strong performance of financials and their ensuing popularity has led to ballooning concentration risk.

Financials currently represent nearly 50% of the market

The chart below shows the strong performance of the financial sector, relative to industrials and resources. This has led to financial stocks (including real estate investment trusts) representing approximately 47% of the total market. Despite the strong price run for financials, proponents of passive investing are silent on the growing risk that this holds for their clients.

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Source: Allan Gray

Some may argue that banks are not necessarily expensive based on simplistic measures such as the price to earnings (P/E) ratio. However, when you consider the fact that banks are trading on record earnings, it is clear that these metrics mask how expensive they have become. At a global level, Australian banks are among the most expensive, yet their long-term opportunities are quite restricted. After all, they are splitting the fortunes of a population of 23 million people and have historically not excelled in any foreign market expansion.

Increasing unemployment and debt are threatening the outlook for financials

Australia has not experienced substantial economic hardship for over 20 years, leading to bullishness in our economic power and strength. Unemployment has recently increased for the first time in two decades. It’s been approximately 22 years since Australia experienced substantial unemployment. In the early nineties it exceeded 10%.

Considering the effect that this can have on debt and declining loan growth, the outlook for financials may be even less promising. In addition, bank provision for bad debt is just one sixth of what it was in June 2009. Zenith Investment Partners highlights that historically there has been a strong inverse relationship between declining provisions and rising share prices¹. This could perhaps imply that bank share prices have had their run. In addition, there has been an increase in the ratio of debt to disposable income since the early nineties. Despite declining interest rates, the level of debt relative to disposable income is still very high.

Concentration risk within a country is especially dangerous

As concentration risk changes in a market or sector, the stock specific risks for underlying investors can rise. Investors may not be aware of this risk because they are unlikely to monitor the underlying weightings of securities in a passive strategy.

A research paper by Vanguard in September 2012 acknowledges the risks of investing in single country markets where there are high levels of concentration risk. Vanguard identify a variety of countries where this is the case, including Hong Kong and Russia, which derive a substantial proportion of their market capitalisation from financials and the energy sector respectively. The research suggests that investing in the Russian market may well depend on the investor taking a view on the energy sector. In an extreme example, the technology boom of the late nineties led Nokia to become 70% of Helsinki’s stock exchange market capital, 43% of corporate research and development spending, 21% of total exports and 14% of corporate tax revenues in Finland. This clearly shows that diversification is not always a feature of a passive strategy. At its peak, Nokia was the largest company in Europe trading on a P/E of 70 times. Today, it trades with a market capitalisation of around one tenth of its June 2000 tech boom peak.

So in thinking about this, how is Australia different? The growing exposure to financials, specifically the big four banks, is increasing passive investors’ exposure to concentration risk. It is unclear if anything will derail the banks going forward, but this doesn’t diminish the reality that the concentration risk in passive investing in Australia has grown. The intelligent investor should therefore seek to find better value elsewhere.

If you are waiting for the passive investment industry in Australia to alert you to this issue, you could wait a while. Despite the industry’s own research, their large sales targets and expectations mean that warning investors against concentration risk will likely rank behind their desire to meet targets and in turn preserve self-interest.

To find value you must be willing to invest in a way that is different to the crowd

To achieve true diversification you have to take on the risk of being different. At Allan Gray, we build portfolios that reflect this view. We prefer to be active managers because we believe true diversification is only possible in the Australian market if you don’t constrain yourself to the weights of stocks and sectors in the benchmark. You need to be more concerned about price and value. We don’t pay attention to companies just because they are large or represent a significant part of a market, unless we can find value in these companies.


¹Sector Report Australian Shares Larger Companies – June 2015

Chris Inifer is Head of Retail at Allan Gray. Chris holds a Bachelor of Business Economics and Finance (RMIT University) and a Postgraduate Diploma (with Distinction) in Financial Planning.