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Wolves in Sheep's Clothing

The term ‘herd behaviour’ comes from the behaviour of animals in herds, particularly when they are in a dangerous situation such as escaping a predator. All of the animals band closely together in a group and, in panic mode move together as a unit. It is very unusual for a member of a herd to stray from the movement of the unit. This term also applies to human behaviour, and it usually describes large numbers of people acting the same way at the same time. It often has a connotation of irrationality, as people’s actions are driven by emotion rather than by thinking through a situation.


The volatility experienced in equity markets can take its toll on even the most prudent investor and may induce emotional responses rather than rational ones. Investors may find comfort in blindly allocating to a broad market index and following market consensus, just as a sheep may find comfort in its flock. However, the following article will outline how indices are often wolves dressed in sheep’s clothing and a more differentiated approach should be applied to investing in order to achieve success over long periods of time.


Index Concentration

Broad market indices are often believed to offer more diversification benefits than they actually do and usually have an over-reliance on a relatively limited number of well-known stocks that drive returns.


Concentration can be measured using the Herfindahl-Hirschman index (HHI). HHI is the sum of the squared weights of the individual stocks in the portfolio. HHI ranges from 1/n (an equally-weighted portfolio) to 1 (a single stock portfolio). The effective number of stocks is the reciprocal of the HHI –



An index with 500 stocks might have an HHI of 0.01 and therefore, an effective number of stocks of 1/0.01 = 100. The fact that 100 is less than the number of stocks in the portfolio reflects the disproportionate effect of the larger weighted stocks on the index. An equal weighted index of 500 stocks would have an HHI of 0.002 and an effective number of stocks of 1/0.002 = 500.


In order to illustrate the concentration present within indices, we have analysed the S&P 500 index. The S&P 500 index currently has 505 holdings, an HHI of 0.014 and an effective number of stocks of just 70. In addition, as reflected in the graph below, the top 10 holdings within the S&P 500 index constitute approximately 27 percent of the index, with the remaining 495 holdings accounting for 73 percent.



Source: Morningstar Direct.


Another important factor to consider is the current industry concentration of the top holdings within the S&P 500 index. In previous decades, as reflected in the below table, the largest 5 companies reflected a more heterogenous mix of industries, including oil (Exxon, BP), electronics (Eastman Kodak, General Electric), and other non-tech sectors (General Motors, Walmart, Proctor & Gamble). By contrast, currently the top 5 companies are technology companies. Therefore, the returns of the S&P 500 index are primarily driven by a basket of 5 competitors within a single industry, rather than representative increases across industries.


Source: Factset


It is clear from the above that caution must be applied when allocating to an index and an understanding of the underlying holdings is crucial, otherwise investors will be lulled in into a false sense of diversification.


The Baymont Wealth Approach

We at Baymont believe that the key to long term investment success is to take a highly differentiated approach as opposed to blindly allocating to broad market indices. Our investment philosophy is based upon an active allocation to quality companies that hold long-term competitive advantages which will enable them to deliver consistent growth throughout market cycles, thereby potentially delivering superior performance to a broad market index. In addition, we identify and allocate to companies that have the following common holding attributes, which we believe are key in delivering consistent growth over time –


Conclusion

In times of market stress, comfort can be found in a passive allocation to a market index. However, to quote Robert Arnott, “In investing, what is comfortable is rarely profitable” and as illustrated indices are often concentrated in a handful of companies and returns are ultimately defined by market consensus. Therefore, at Baymont we believe that successful investing should be based upon placing emphasis on identifying quality companies that will be able to successfully compound over time regardless of the macroeconomic backdrop.

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