25 Nov, 2021

Read the small print

INSIGHTS Market Insight

When was the last time you regretted not reading the small print? Think of when you booked an all-inclusive stay at a deluxe hotel and ended up paying extra for breakfast. Or when you had to pay a cancellation fee for your ‘cancel anytime’ gym membership. This risk of missing a non-negligible detail manifests itself in a multi-year trend seen in investors’ allocation decisions – that of accelerated inflows into passive equity strategies and outflows from active equity strategies (Fig 1).  


Figure 1: Cumulative flows to US active and passive equity strategies, for the period 2005-11-30 to 2020-11-30.  
Source: BofA Global Research, EPFR Global 

Passive strategies have witnessed impressive inflows over the past decade primarily due to their comparatively low fees and tax liabilities as well as the struggling performance of their active counterparts. However, what you see is not always what you get! In this piece, we look at a broad range of country indices and assess the idiosyncratic risk exposure underlying a supposedly broad allocation to a country. Fig 2 illustrates that a handful of companies account for half the volatility of a country’s index, an observation that is consistent across both developed markets (DM) and emerging markets (EM). In the largest two markets (US and Japan), which comprise c. 60% of the MSCI ACWI, less than 10% of listed companies account for half the volatility of the respective index. It is also remarkable that this number exceeds ten companies in only seven countries.  

Figure 2: The figure shows the number of companies that contribute to half the volatility of each country index, for the period 2018-08-31 to 2021-08-31. Country indices consist of MSCI ACWI constituents listed in the respective country. Constituents are market-cap weighted. Source: Arabesque Asset Management, MSCI 

The sector and revenue breakdown of these companies is perhaps even more striking. Spain’s two biggest banks, Santander and BBVA, account for 30% of index volatility. This is despite deriving only a small portion of their revenues onshore (15% and 24% respectively). Sweden’s industrial companies (Volvo, Sandvik and Atlas Copco) derive less than 40% of their revenue from Europe. LVMH, Christian Dior, Hermes and Kering account for one quarter of France’s index volatility, while the bulk of their revenue is derived from Asia (40%, 41%, 58% and 45% respectively). So much for ‘exposure’ to home economies.     

It is important for us to echo that this is not a DM vs EM story. Consider, for example, Australia and India, which currently have an equivalent weight in the MSCI ACWI. Four of Australia’s eight companies represent the country’s biggest banks, compared to India’s eleven companies spread out across five different sectors. Or take Italy and South Africa, where three banks account for one third of Italy’s index volatility, while South Africa provides a broader sector diversification. This is despite Italy having twice the weight of South Africa in the MSCI ACWI.  

Can investors truly diversify their portfolio by allocating passively? The risk underlying market-cap weighted passive strategies may be driven by a small number of companies, which may not be diversified from a sector exposure perspective and whose apparent and actual country exposure may differ. At Arabesque, we are disciples of diversification; our portfolios are equally weighted and cognizant of sector and country biases. In other words, we feel that we have read the small print. 


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