What does a bigger BHP mean for investors who are trying to maintain diversity in their portfolio?

This week the AFR flagged some of the issues around what it calls the ‘super-sizing of BHP.’ When the company’s structure is unified, it’s expected to send significant shock waves through the local market.

By consolidating its dual-listed company structure, BHP will leap ahead of CBA and become “numero uno” with an ASX200 weighting of about 10 percent!

Is this good news or bad news for investors? The answer to that could depend largely on whether you’re an active or passive investor.

Investors exposed via passive ETF products will be presented with an index even more concentrated in resource shares. Concentration risk is inherent in many market-cap weighted indices, particularly the ASX.

If you were to take a passive approach on the ASX, roughly 51% of your money would be invested in just two industries, financials and materials. Moreover, the top 10 companies would represent around 50% of your portfolio.

Now we would agree that there are instances where passive, index-tracking investments make sense, particularly when you’re bringing more diversified international equities indices into a broader portfolio construction. However, a passive ASX100 approach can short-change investors of diversification by exposing them to high levels of both industry sector and stock-specific risk.

At Elston Asset Management, a core tenet of our investment philosophy is genuine diversity. One of the ways we put this into action is through our investment policy which outlines the parameters by which we can construct portfolios.

By adopting a more pragmatic approach, we remove the inherent bias within the benchmark by employing a fixed weighted methodology. This is implemented primarily through the limitations placed on position size and hard minimums and maximums. We also limit industry groups, with a minimum of 8 GICS industry groups required to be represented in the portfolio.

 

While ensuring proper diversification, these policy constraints also enhance opportunities to exploit market inefficiencies. They allow not only the capture of company-specific returns but also the ability to benefit from multi-sector exposures returns, which is an influential driver of returns over the longer term.

Importantly, rather than being determined by market cap, allocations are driven by valuation/relative attractiveness. This is a forward-looking concept that considers Estimated Total Return (ETR) with adjustments for the level of risk.

So, that all sound great, but what does it look like in practice? In short, it results in a portfolio that looks nothing like the benchmark.

 

The grey shaded area on the chart represents a passive exposure to the ASX100. The overlayed coloured bars represent the individual businesses within Elston Australian Large Companies portfolio, and the different colours representing the 11 GICS industry groups currently represented within the portfolio.

As you can see, we are taking truly active positions at both the stock and industry level relative to the benchmark. The key difference between Elston’s approach and benchmark-weighted approaches are that we have the flexibility to avoid weightings in large benchmark constituents if the company or sector fundamentals do not warrant it.

Being benchmark unaware enables Elston to provide investors with adequate diversification by avoiding the artificial biases resulting from short-term benchmark-driven investing.

While it may seem initially restrictive, the policy allows us to identify opportunities amongst the many potential sources of return and gain the flexibility to create a portfolio that offers consistent and stable performance over time.

 

If you would like more information please call 1300 ELSTON or contact us to speak to the Asset Management team.