24 February 2014
In an industry that's sometimes criticised for being overly homogenised, an Australian equities ex-20 strategy can offer a unique opportunity for investors to add value. Paul Cuddy, CEO of Bennelong Australian Equity Partners, discusses the underlying benchmark of the Australian market, and explores strategies that may offer clients a solution to some of the more common challenges with constructing a portfolio.
The Australian equity market is characterised by the dominance of the ‘mega cap' stocks. This structural anomaly distorts the weighting that the top 20 stocks represent in the S&P/ASX 300 index. The chart below presents a very powerful example of that dominance.
Chart 1: ASX 300 stock weights
Approximately two-thirds of the index is accounted for by just 20 stocks. This disproportionate representation creates a number of problems for investment professionals, which can potentially lead to sub-optimal outcomes. Most large cap Australian equity portfolios have investment constraints that don't allow for individual positions to stray away from the stock's benchmark weight. Typically, this means that most managers will need to hold a position in a stock, whether they like it or not. This is because most managers are restricted by investment parameters, which can limit an individual stock holding to an active range of the index ±5-6%.
Investors are justified in seeking more genuinely active solutions that complement their existing holdings. A complementary benchmark, which can be used alongside an investment in the broader benchmark, is the S&P/ASX ex-20 benchmark. One of the benefits of this benchmark is that it's not dominated by a handful of stocks as is the case with the S&P/ASX 300.
Traditionally, portfolios have been constructed using a blend of three to four Australian equity managers, and one to two smaller cap managers. This has been a simplistic rule of thumb that's not necessarily thwarted the dominance of the top 20 stocks in the S&P/ASX 300; the argument being that limited exposure to the ex-100 market is wiser, given the dramatic fall in market cap and liquidity. This argument has proven to be a good rule of thumb, but has nevertheless meant that portfolios have an under-representation in the larger cap stocks outside of the top 20 - those that have strong brands with robust business models and don't suffer as much from illiquidity issues.
An ex-20 Australian equities strategy presents a compelling proposition for investors and not surprisingly, is attracting a growing investor audience. With structural anomalies suggesting that many portfolios are over exposed to the market's top 20 stocks, an ex-20 strategy offers a complementary alternative to the more traditional funds, harnessing the investment potential that lies within the ASX300 but outside the top 20.
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