Pension fund trustees should be aware of stock concentration in the FTSE All-Share Index and consider how best to manage their investment portfolios to reduce the impact of UK equity market concentration, says Mercer Investment Consulting.
The UK equity market is relatively concentrated when compared to other main indices. The 10 largest companies comprise 43% of the market capitalization of the FTSE All-Share Index. UK pension funds have traditionally invested around two-thirds of their equity allocation in the UK equity market. Although the bias to this market has been falling, it remains significant.
In July, Shell’s weighting in the index will increase from around 3% to over 7%, assuming the unification with Royal Dutch into a single listing is approved. Exposure to Shell will typically double in passively managed UK equity funds, resulting in less diversified investment portfolios.
Following the merger, the UK equity market’s weighting towards the resources sector – mainly oil and gas – will become further pronounced relative to the world index. Resource sector stocks will account for over 20% of the FTSE All-Share Index against a FTSE World Index exposure of 10%.
“Pension fund trustees should be aware of the need for diversification in their asset portfolios,” said Andrew Green, Head of Investment Strategy at Mercer. “Excessive stock concentration can make pension funds more vulnerable to changes affecting certain companies or sectors.”
He continued: “Increased concentration in the UK equity market has been one of the principal factors behind our advice in recent years for clients to consider the balance between UK and international equity exposures.”
Bernard Nelson, European Principal at Mercer, commented: “Trustees can offset the effect of concentration by reducing UK equity exposure and allocating more funds to international equity markets.” He added: “Another solution would be to cap the size of individual stocks in the UK equity market. Adopting as a benchmark the FTSE All-Share Index with a 5% cap on individual stocks strikes a balance between dealing with stock concentration and not being too disruptive to the underlying investment portfolio.”
FTSE Group has today announced that it will produce a 5% capped version of the All-Share Index and, following discussions with Mercer, a leading index fund provider has indicated that it would consider operating a 5% capped index fund if there were sufficient demand.
Nelson said: “Trustees’ ability to address the issue of stock concentration will largely depend on their individual investment arrangements and the attitude of their investment managers.”