Equity markets are highly concentrated, we know that.
But many investment factors – stocks grouped together because they show certain characteristics – are also very concentrated and can also be prone to overcrowding, writes Style Analytics’ head of research, Damian Handzy.
Momentum, Low Volatility, Growth and Quality stocks are more concentrated now than over the past decade.
Over the past four months of market recovery since early April to the end of July, just 10 stocks generated 43% of the returns in Growth’s best performing 100 stocks.
Similarly, in Momentum, 10 stocks accounted for 45% of returns.
The culprits? Apple, Amazon and Microsoft appear in the top 10 stocks for three different factors.
But Value; stocks which trade at a lower price relative to fundamentals such as dividends, earnings, or sales, is much less concentrated, with just 25% of returns from the 100 best performing value stocks coming from just 10 stocks.
So Value may offer a natural hedge.
Looking at the numbers
We took the performance of Value, Growth, Quality, Momentum and Low Volatility factors from April to July 2020.
For each factor, we measured the cumulative cap-weighted returns of the top 100 best performing stocks. We did the same for the broad-market ‘index’ made of the top 100 performing stocks out of the largest US 1,000 stocks.
The results are shown below in Figure 1:
Figure 1: Cumulative returns of the factor groups over the past 4 months showing that factor returns are concentrated. Source: Style Analytics.
The overall market index shows the highest level of concentration (yellow diamonds) because it includes the top stocks of the individual factor groups.
Of the factor groups, Low Volatility (red triangles) and Momentum (black squares) show greatest concentration followed by Growth (green triangles) and Quality (purple squares).
Value (blue diamonds) is a clear outlier showing the lowest level of concentration. The graph shows the top five stocks generated only 15% of returns in the period.
Company concentration
Interestingly, a number of companies overlap across two or more factors. The top 10 stocks for each factor are shown below with the cumulative contribution to that factor’s overall returns.
Three companies stand out.
Apple (included in Low Volatility, Momentum and Quality), Amazon (Low Volatility, Momentum and Growth) and Microsoft (Low Volatility, Momentum and Quality).
Seven companies appear in two lists: Alphabet (Low Volatility and Quality), UPS (Low Volatility and Quality), S&P Global (Momentum and Growth), Tesla (Momentum and Growth), Newmont (Low Volatility and Momentum) and Nvidia (Momentum and Growth).
Tellingly, Value is the only factor group without an overlapping stock.
What does history tell us?
We performed the same analysis over the past 10 years and show the results in Figure 3:
Figure 3: Cumulative returns of the factor groups over the past 10 years showing that factor returns have long been concentrated. Source: Style Analytics.
Growth shows the highest concentration over the period. The top 10 Growth stocks have been responsible for 42% of Growth’s top 100 best performers’ returns, which is similar to current levels.
Other factors have shown less concentration: Low Volatility (34%), Momentum and Value (both 31%) and Quality (30%).
The abnormally high level of concentration across all factors apart from Value and the overlap in the stocks means that today’s factors do not offer as much diversification as usual. In more normal markets, factors tend to be a natural hedge against one another.
Today’s factors provide less diversification and less downside protection.
The overlap – especially in their highest performing stocks – means that factors are more correlated to each other than normal.
Of all the factors analysed, only Value provides diversification benefits. It is less concentrated and has no overlap with the others.
Value has been underperforming the market, but it may be a much-needed diversification for investors looking to hedge.
This article was written for Expert Investor by Damian Handzy, head of research at Style Analytics.
