THE proposed takeover and subsequent removal of Foster's and ConnectEast from the Australian Securities Exchange will further shrink the universe of large liquid stocks in which fund managers can invest.
With the continued dominance of resource companies and the big four banks, institutional investors are facing a diversity problem.
Fund managers have told BusinessDay that the static initial public offer (IPO) market is adding to the thinning out of the equities market, with the lack of IPOs cutting off supply of new industrial stocks.
"One of the things that refreshes the pipeline for fund managers and investors generally is a good IPO market and that has been stuffed for five years," said Donald Williams, of Platypus Asset Management.
"The market is becoming more narrow because you have these six mega-caps, the big four banks, BHP Billiton and Rio Tinto, that account for a massive part of the index and it's sort of hard to add value."
For many of the largest fund managers, this has forced them to investigate middle-sized companies and small-caps to unearth tomorrow's leaders and eke out premium returns. Some institutional investors are currently the most heavily weighted in mid to small-caps since before the GFC.
Australian Unity Investments chief executive David Bryant said the increasing concentration among largest companies and their weight compared to the rest of the index had been a problem for fund managers for some time.
"The top 20 stocks are more than half the market capitalisation in Australia and are very heavily weighted to resources, financials and the big insurers. And when you talk about liquidity and size, it does fall away quickly from there," Mr Bryant said.
A quick scan of the ASX's biggest stocks highlights the dilemma. The "gang of six" BHP, Rio, Commonwealth Bank, Westpac, ANZ and NAB account for just under 40 per cent of the S&P/ASX 200 in terms of index weighting.
The takeover of Foster's will remove the only large listed beer business and the 18th biggest stock. Its departure will also leave only five companies in the top 20 that are not financials or resources plays.
It gets worse the higher up the index investors go. Only two stocks in the top 10 (Telstra and Woolworths) are not banks or resources companies.
"I don't think its a problem with takeovers, more a problem with the commodity prices," said Orbis Investment Management managing director Simon Marais. "It has skewed our whole capital allocation to such an extent that all the money flows into resources and that's why it becomes the whole index."
Argo Investments chief executive Jason Beddow said the Australian market was lacking sectors that typically provide diversification.
"Australia is a very concentrated market . . . you don't have a lot of mid-tier companies and sectors such as technology or health. There isn't much."
Mr Beddow, whose Argo looks after an equities portfolio valued at more than $3 billion, said the poor IPO market had made the concentration problem worse.
"It's a fairly skewed market already, the industrial side of the market has been probably shrinking for the last decade as banks and the resources have grown.
"So to be able to invest across the broader spectrum of the economy, from that perspective, it is becoming more limited.
"And since the GFC, so nearly five years, we haven't had a strong IPO market, plenty of small resources floats, that's fine, but not really investable for the big guys and we are not getting those new industrials coming through."
Mr Marais agreed, saying the IPO assembly line had almost ground to a halt. "It's not that the takeover cycle is too high, I think the replacement cycle is too low.
"There aren't enough new companies coming up while resources sucks up all the capital in the economy.
"If you look at healthy economies there are a healthy flow of new companies all the time. You need that conveyer belt of small companies."
Mr Williams said the growing dominance of a few stocks also created earnings problems for managers.
"All six of those mega-stocks [BHP, Rio, the banks] are relatively lacklustre when it comes to growth. BHP and Rio have only got 2 to 4 per cent volume growth, and it's basically just a call on commodity prices, while the banks have got very slow earnings growth over the next few years."
Mr Williams said his search for better value and returns had led to mid-caps. "We are doing more in mid-cap and small-caps than we have since 2004-5. We are doing less in top 20 than we have done for a long time trying to find growth."
Ausbil Dexia's head of equities, Paul Xiradis, said diversification was not an impossible task. "The Australian market has become more narrow, but you just have to be more selective, you need to take a wider look at the market."
Frequently Asked Questions about this Article…
How will the proposed takeover of Foster's and ConnectEast affect the ASX and everyday investors?
The article says the takeovers will shrink the pool of large, liquid ASX stocks — Foster's is the only large listed beer business and its removal (along with ConnectEast) reduces the number of big industrial names available. That makes the market more concentrated and can limit opportunities for fund managers and investors who rely on large, tradable stocks.
Why are fund managers worried about concentration in the Australian share market?
Fund managers told the article that resources and the big four banks dominate the index, creating a concentration problem. The top 20 stocks are more than half of Australia’s market capitalisation and many are in resources or financials, which makes it harder for managers to add value and build diversified portfolios.
What is the 'gang of six' and why does it matter for ASX investors?
The article defines the 'gang of six' as BHP, Rio Tinto, Commonwealth Bank, Westpac, ANZ and NAB. Together they account for just under 40% of the S&P/ASX 200 index weighting. That level of concentration means a large part of index performance hinges on a few companies and sectors, reducing diversification benefits for investors focused on Australian equities.
How has the weak IPO market influenced investment choices on the ASX?
According to fund managers quoted in the article, the static IPO market over the past several years has cut off supply of new industrial stocks. With fewer new, investable companies listing, especially outside of small resource floats, managers have less fresh stock to diversify into — worsening the market’s concentration.
How are fund managers responding to a narrower Australian market?
The article reports many large managers are shifting away from relying solely on top-20 stocks and are exploring mid-sized and small-cap companies to find growth and add value. Some institutions are currently more heavily weighted in mid and small caps than they have been since before the GFC.
Which sectors are underrepresented on the ASX and why does that matter for diversification?
Argo Investments’ chief executive told the article that sectors that typically provide diversification — like technology and health — are limited in Australia. The market has relatively few mid-tier companies in these sectors, which reduces options for investors seeking exposure beyond banks and resources.
Does the dominance of a few large stocks affect earnings growth expectations for investors?
Yes. The article notes fund managers view the mega-cap resources and banks as relatively lacklustre for growth (for example, BHP and Rio cited with modest volume growth and banks with slow earnings growth). Heavy weightings in such stocks can therefore limit aggregate earnings growth for index-focused portfolios.
What practical steps can everyday investors take if the Australian market feels too concentrated?
Based on the article, investors can broaden their search beyond the top-listed names: be more selective, consider mid-cap and small-cap opportunities, and look more widely across the market. Fund managers in the story said this wider approach helps restore diversification when large-cap weightings dominate the ASX.
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