Impact of mega caps on portfolio construction

• Regardless of the factor, it can be seen that an equal weighted portfolio performed significantly worse in 2023 due to the mega cap effect.
• Despite the mega cap effect, value and low leverage outperform the global equity market, due to a favourable interest rate effect.
• Controlled factor strategies achieve similar information ratios over the long term, regardless of the weighting scheme.
   

Equal weighting vs market capitalisation weighting

The dominant theme of 2023 is the significantly positive perfor­mance of mega caps, which was analysed in detail in the Equity Insights articles #30 & #31. While there is no evidence of any significant influence over the past 20 years, there has been a significant, idiosyncratic mega cap effect on the global equity market for the first time in recent years, which cannot be substi­tuted without a noticeable return effect despite controlling for all value-driving factors.

Dealing with this idiosyncratic effect relies on the portfolio's weighting scheme, determining the (potential over- or) under­weighting of mega-caps. In an equally weighted portfolio, there 
is a significant underweighting of mega-caps. In a market capi­talization-weighted variant, the focus is on active deviation from the original index weighting, within ±1 per cent in the Assenagon Equity Framework.

After examining the size factor in the previous article (Equity Insights #32), which by definition is most exposed to the mega cap effect, in this article, we focus on other relevant factors of the global equity market.

Influence of the weighting scheme in the case of the value factor

Similar to the size factor, a higher influence of the mega-cap effect is assumed in the value factor. Mega-caps often align with technology or growth companies, generally underweighted in value strategies.

Figure 1 shows the relative performance of two controlled value strategies compared to the global equity market, which differ purely in terms of their respective weightings. Despite the differ­ent weighting schemes, both variants only show an active devia­tion from the global equity market in terms of the value and leverage factor characteristics. All other value-driving aspects, such as country and sector allocation as well as other factor effects, are neutralised compared to the benchmark. This means that the factor characteristics are managed independently of the weighting scheme as part of the Assenagon Equity Framework.

Fig. 1: Relative performance compared to the global equity market
(December 2022 – December 2023)

Similar to the size factor, the mega cap effect has a significant influence on the relative performance, as the market capitali­sation weighted variant clearly outperformed the equally weight­ed variant by around 3.8% this year. Interestingly, the market capitalisation weighted variant slightly outperformed the global equity market, despite the underweighting or lack of allocation to the technology-heavy mega caps described above.

Favourable interest rate impact due to low leverage

Compared to all other factors, leverage stands out in 2023. Al­though there is a clear discrepancy in terms of performance between the different weightings (see Figure 2), the equally weighted variant shows a neutral performance relative to the global equity market. In contrast, the market capitalisation-weighted strategy performed significantly positive.

The reason for this is the continued dynamic development of in­terest rates, particularly in the medium to long-term section of the yield curve. For the leverage factor, this translates into a posi­tive outcome: Companies with lower debt levels are less affected by rising refinancing costs. This also benefits the value factor, generally characterized by a lower share duration (Equity Insights #12) compared to the global equity market.

Fig. 2: Relative performance compared to the global equity market
(December 2022 – December 2023)

Assenagon Equity Framework

Table 1 shows the average values with regard to the risk-return characteristics of all relevant factors in the Assenagon Equity Framework since 2000. As can be seen, there is a significant posi­tive premium in both cases regardless of the weighting scheme; regardless of the idiosyncratic mega cap effect in 2023, equal weighted factor portfolios outperform their market capitalisation weighted counterparts by 0.3 per cent p.a. in the long term.

Tab. 1: Average risk-return characteristics of all factors since 2000

However, it can be seen that the choice of weighting scheme im­pacts the distribution of returns. Equal weighting leads to more extreme characteristics in the frequency distribution, i.e. a high outperformance or underperformance occurs significantly more frequently than in the case of the market capitalisation weighted variant. In the summary statistics in Table 1, this is reflected in the higher tracking error and relative maximum drawdown com­pared to the global equity market. The information ratio (outper­formance/tracking error) is therefore similar regardless of the weighting scheme implemented.

For the investor

Ultimately, the achievable risk/return profile should always guide the choice of the weighting scheme.

In holistic portfolio construction, the pure factor premium as the sole performance driver results in no significant difference in the information ratio between the two variants in the long term. Therefore, the variant that most closely corresponds to the individual risk-bearing capacity in relation to the benchmark should be favoured. In a world in which shares such as Apple are larger than entire sectors, this should be appropriately taken into account in the allocation.

P S: Read about the difference between active and passive investing in the next issue.