Benchmark concentration and the effects on active portfolios

Concentration risk in a new regime

Over the last five years, equity market concentration has climbed significantly, meaning a smaller number of stocks have increasingly driven the bulk of the returns within equity markets. For passive investors, increased concentration reduces diversification and increases volatility, leaving major indices more susceptible to the idiosyncratic risks of its largest constituents.

Key findings

Active managers have tools to adapt. As benchmarks become more concentrated, the way portfolios are constructed becomes more important for maintaining diversification.

In this research, we investigate the relationship between active risk and benchmark concentration across three strategies: Long-only, partial long-short, and full long-short implementations.

Our simulations (as seen in the full paper) demonstrate that:

(1) Partial long-short portfolios are more robust

Partial long-short (130/30) implementations have shown greater resilience to increased benchmark concentration compared to long-only portfolios. The sensitivity of forecast IRs to changes in benchmark breadth has been significantly lower for partial long-short strategies, making them a preferred choice for investment managers seeking consistent risk-adjusted returns.

(2) Portable alpha strategies are attractive for flexible investors

Full long-short market neutral strategies, when combined with index futures, can target alpha independently of equity benchmark concentration effects.

(3) Active risk adjustments for long-only investors

For long-only investors who cannot implement partial long-short strategies, adjusting active risk levels is crucial. Reducing risk levels as benchmark concentration increases helps maintain consistent IR levels. This approach is particularly important as sensitivity to benchmark concentration effects is amplified at lower active risk levels.

Final takeaways

As benchmarks become more concentrated, investors may consider an evolved approach. In our view, portfolio flexibility is key to seeking consistent alpha. Whether through active risk management, partial long-short design, or portable alpha overlays, active managers can adapt and thrive even in a market dominated by a few giants.