The Risk of Concentrating Too Much
When the topic of concentration risk comes up in portfolio management, normally folks think about the possibility of holding a large individual stock position in their account. We recently ran into a situation with a planning client who inherited concentrated stock positions from a family member. The client wished to memorialize their loved one by holding onto these stocks. Another way concentration may occur is when a client works in a particular industry and feel they have a pulse on the companies in that industry. Indeed, it is not uncommon for us to see medical professionals heavily invested in healthcare companies, or military defense executives invested in industrial and cybersecurity companies. Of course, this type of concentration risk can be mitigated through a variety of strategies, including properly diversifying away from those stocks, overlaying a covered call strategy, or gifting portions of those stocks if you have charitable intentions.
From time to time, though, we think it is worthwhile to revisit some other forms of concentration risk, especially if an investor is self-managing their portfolio. An investor may be exposed to underlying concentrations in the holdings of either passive index funds or actively managed mutual funds. For example, most investors are familiar with the S&P 500 index fund; however, they may not be familiar with the fact that ten of the 500 companies account for approximately 30 percent of the index value. In fact, a select seven, referred to as the ‘Magnificent Seven’ represented 26 percent of the index in 2023. While this level of concentration has occurred in the past (i.e. 1930s, 1960s), according to Morgan Stanley, “The rate of increase in concentration over the past decade was the steepest in history.” Moreover, other types of concentration risk may exist in certain sections of the investable market. For example, emerging market index funds have a high concentration of assets, roughly about a quarter of their values, invested in China. Therefore, you may not be as diversified as you initially thought in these ‘baskets’ of stocks.
Concentration risk can be even more acute in actively managed mutual funds, as those managers retain full discretion on investment decisions. If an investor limits his research and fund selection to news articles and performance, they may inadvertently take on various forms of risks, including concentration risk. For example, Baron Partners Fund (BPTIX) is run by the renowned manager Ron Baron, whose experience and investment management skills are celebrated by colleagues and competitors alike. This fund holds a total of 19 companies, the top ten of which account for 95 percent of the fund’s value. Its top holding, Tesla, accounts for 33 percent of the fund’s value, as of 09/30/2024. Although Mr. Baron has held Tesla for over a decade and has made a lot of money for shareholders, it nevertheless exposes a new investor to concentration risk. Indeed, Tesla’s position started at 6-7 percent of the fund and has ballooned to its current weighting. Even more drastically, the Fairholme Fund (FAIRX) operates with a very flexible mandate and currently holds a single stock, The St. Joe Company, for nearly 80 percent of the fund’s value, as of 05/31/2024. While the fund’s motto is “We invest with courage of conviction. We ignore the crowd. We swing big at our best ideas,” it didn’t exactly work well for them when their largest position in 2011 – AIG – lost 52 percent of its value.
Yet another type of concentration risk is fund family risk, which is far less common but nevertheless present for some investors. If an investor decides to open an investment account at a company like Vanguard or Fidelity, they have the option of opening a fund account, which may limit an investor to the fund family’s proprietary offerings, as opposed to a brokerage account that allows for a greater array of investment choices. If an investor chooses to open a fund account, by design they are exposing themselves to fund family concentration risk, as they would only invest in Vanguard funds or Fidelity funds. Usually, this is not a huge risk, but there have been instances in the past when investors or even advisors have had to navigate rough waters with certain fund families. In the early 2000s, the mutual fund industry was mired with scandals and illegal activities. At that time, I was working at a small wealth management firm that oversimplified its client investment offerings to just a handful of fund companies, including MFS, Putnam, and Davis. One fund company was hit especially hard with scandal and, apart from massive headline risk, also experienced incredibly large and immediate outflows from its various mutual funds. This resulted in the wealth management firm I worked for to make an executive decision and terminate their agreement with this fund company and remap all client account funds nearly overnight.
While concentration risk is more subjective than objective, each investor should weigh the pros and cons of the structure of their account and investments to mitigate these portfolio imbalances. Indeed, we have seen varying levels of all these types of concentration risk with our financial planning clients, and work with them to mitigate (or at least understand) the risks they are taking.
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Sources:
https://en.wikipedia.org/wiki/2003_mutual_fund_scandal
https://www.ssga.com/us/en/intermediary/insights/market-concentration-risk-and-how-to-diversify-now
https://www.fairholmefunds.com/
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