Mega Caps: Position vs. Position
EQUITY INSIGHTS | No. 43
- The main focus is often on the top 10 holdings of a portfolio. In reality, however, the top 10 active weights are usually more meaningful.
- Positions that may not appear style-consistent at first glance can still add significant value from the perspective of active positioning.
- Looking solely at active share is often insufficient, as it can arise in very different ways.
Absolute Position vs. Active Positioning
In actively managed fund strategies, companies within a portfolio are usually discussed from an absolute perspective, irrespective of the underlying investment style: Is a particular stock included in the portfolio or not? Does the company fit the investment style being pursued?
In the context of most active managers aiming to outperform a benchmark, however, this perspective can be misleading.
Rather than focusing on the absolute position, the emphasis should be on active positioning. Even if a stock may appear unattractive or “unsuitable” for the underlying investment style — for example, a company with growth characteristics in a value strategy — it may still make sense to hold a small position that is underweight relative to the benchmark, i.e. from the perspective of active positioning.
To illustrate the importance of active positioning compared with an absolute perspective, the following analysis examines two global equal-weighted strategies with a focus on the value and size premia.
In principle, these strategies have three characteristics that stand in stark contrast to the global equity market: historically high equity valuations, which are anti-value; large caps, which are anti-size; and record-high index concentration dominated by just a few companies, which runs counter to equal weighting.
Example: Global Value Size Strategy
The two equal-weighted value size strategies are constructed holistically. This means that, beyond the intended return drivers of value and size, all other effects — such as country, sector and factor effects — are neutralized relative to the global equity market.
In addition, to achieve the best possible diversification, the 250 selected companies are equal-weighted at 0.4 percent per position, whereas the global equity market is weighted by market capitalization. The only difference between the two strategies is that one strategy can invest in all stocks except the ten largest companies at the respective point in time during portfolio construction: Value Size ex Top 10. The other strategy, by contrast, can draw from the full universe: Value Size incl. Top 10.
On the one hand, one could argue that the ten largest companies have no place in a strategy focused on inexpensive small and mid-cap companies. This would be the absolute perspective.
On the other hand, under the equal-weighting approach, the maximum cumulative allocation would be 4 percent — 0.4 percent per stock across ten stocks within a portfolio of 250 equal-weighted positions. Compared with the global equity market, this represents an underweight of more than 20 percent. This is the active positioning perspective.
Figure 1 illustrates the underweight of the two strategies in the current top 10 stocks. If the top 10 stocks are included, the cumulative underweight amounts to 22.9 percent, while their absolute top 10 weighting in the global equity market is 26.9 percent.
This 4 percent position in mega caps has only a marginal impact on the underlying strategy. The portfolio is approximately 56 percent cheaper than the global equity market, while the Value Size ex Top 10 strategy is around 59 percent cheaper. In other words, the value exposure is almost identical. At the same time, even this small position helps with regard to the two quality factors, profitability and leverage, leading to a significantly better profile in this respect.
The example shows that, at portfolio level, both the active positioning and the factor exposure of the two value size strategies are very similar. When analyzing the return-risk profile, however, significant differences emerge. Over the past five years, the ex Top 10 variant has underperformed by around 5 percent in total, while also recording a 0.5 percent higher tracking error.
In the context of the mega-cap rally over the past five years, the difference in returns may not come as much of a surprise. However, the long-term analysis shows that this effect cannot be attributed solely to the performance of mega caps. Figure 2 shows the relative return between the Value Size portfolio including the Top 10 and the ex Top 10 variant over the past 25 years.
As can be seen, excluding the ten largest companies in the universe at the time of portfolio construction has had a negative long-term impact. This stands in clear contrast to the technology-heavy mega-cap effect, which has become particularly relevant only since the beginning of 2019.
Assenagon Equity Framework
Admittedly, the example presented is deliberately pointed. Yet it captures the binary perception of position and positioning very well: What place do mega caps have in a strategy focused on inexpensive and smaller companies?
Such a view unfortunately does not do justice to the role of portfolio construction. Ultimately, the focus should be on the active weight, which is clearly aligned with the intended strategy.
The example shows that, with almost identical factor exposure, better diversification can be achieved — with a positive impact on both return and risk.
Active positioning should generally be the focus for all strategies that are measured relative to a benchmark. After all, the absolute weights of a fund’s top 10 positions, for example, say little about its relative performance or relative risk versus its benchmark.
For Investors
Active positioning is decisive for any deviation from the benchmark. This applies at the level of factors, countries, sectors and individual securities.
In summary, the degree of benchmark deviation can be captured by active share, ranging from 0 percent, which represents perfect benchmark replication, to 100 percent, which represents exclusively off-benchmark positions.
However, an active share of, for example, 80 percent can arise in very different ways. To gain further insight, traditional diversification metrics can be applied to active weights. For instance, the cumulative weight of the ten largest active positions or the effective number of active positions can show how concentrated or diversified a strategy is.
As a result, these metrics ultimately provide insight into the risk profile, particularly relative to the benchmark.
PS: Read the next issue to find out more about the efficient construction of multi-factor portfolios.
