Goodbye to the 'All Ordinaries'

PORTFOLIO POINT: Of the world’s top 10 sharemarkets, Australia’s is the second most concentrated – and investors should take this into account when building their portfolios.

After Switzerland, Australia’s sharemarket is the most concentrated of the top 10 world sharemarkets. Unlike defensive food-and-pharmaceutical-rich Switzerland, however, it also gives investors one of the highest exposures to growth and cyclical stocks. Not surprisingly, this can make our market more volatile, and cause it to fall further in difficult times. Because of this, Australian investors need to think carefully about their local mix of shares and be cautious about devoting too much money to the big companies, the index or index-hugging funds. In this article, we’ll deconstruct the Australian sharemarket index into its key components and offer some suggestions for how you might reconstruct it more safely.

Australia’s concentrated sharemarket

Index funds were created in the US in the 1970s. They are becoming more popular in Australia with the advent of easy-to-trade exchange traded funds (ETF) and concerns about after-fee performance of actively managed funds. Through one low-cost investment into an unlisted or exchange traded fund (ETF), your funds are instantly invested into hundreds of different shares, depending on the asset class and fund type. Even gurus like Warren Buffett recommend indexing investment:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.” (Warren Buffett, 1996 Annual Report of Berkshire Hathaway)

Index funds are especially efficient ways to earn the returns from diversified markets, with many companies operating in multiple industries. However, once you leave the US you enter smaller sharemarkets, where there are fewer companies and fewer industries to invest in. Figure 1 highlights that after Switzerland, Australia is the second most concentrated top 10 sharemarket.

Figure 1: Industry sector (horizontal axis) and stock (vertical axis) concentration of top 10 world stockmarkets as at May 31 2012

When Australians invest in an Australian broad market index fund such as State Street’s STW, Vanguard’s VAS or iShares’ IOZ ETFs, more than two-thirds of their money is spread around only three industries (or two if you count materials and energy as the one “resource” sector) and more than half their money is in 10 shares. In 2010, this used to be a higher 75% and 60%, respectively, before the share prices of banks and BHP and Rio fell more than other companies in recent weeks.

This same concentration risk exists in many actively managed Australian share funds which “hug” the index. Many do so to avoid the embarrassment of underperforming the index. Indeed, any initiative to invest differently from the index is considered “tracking error”.

A close match to Australia in terms of sharemarket concentration is Canada, which has a remarkably similar mix of leading resource companies and well-managed banks. Many Canadians invest, however, in “capped” local index funds, which limit investment in any one company to 10%. Capping was introduced during the dotcom 2000s to prevent then market darling Nortel Networks from becoming more than 30% of the fund. As mentioned previously, that company has since gone bankrupt, providing a good reminder to pay attention to concentration risk in your portfolio!

Deconstructing the Australian sharemarket index

Figure 2 breaks apart the Australian sharemarket as at June 1 2012, based on the composition of the ASX200 index – a market capitalisation index representing the value of the top 200 listed companies in Australia. While this index excludes the worth of some 300 smaller companies, in total those would add less than 10% more and not change the picture. In this chart, the horizontal axis shows the industry sector make-up of the Australian sharemarket. The vertical axis shows the largest companies in each sector.

Figure 2: Industry sector and major stock (holding more than 0.5% of market) composition of the ASX200 at June 1 2012

If your favourite stock is not shown here, it is because it represents less than one twentieth, or 0.5%, of the index and, to be frank, it has little impact on overall sharemarket performance. When Alan Kohler or another commentator talks about the movement in the All Ordinaries or similar ASX200 or ASX300 index on television, they are really talking about what happened with bank and resource stocks, plus Woolworths, Wesfarmers, Telstra, Westfield and CSL – as that’s more than 80% of the market!

In the graph above, you can see the Australian sharemarket is roughly one-third banks, one-third resource companies and one-third “other”. Even within this “other”, Woolworths, Wesfarmers and Coca Cola Amatil are 90% of our defensive consumer staples sector, Telstra is 95% of our telecommunications exposure and CSL is more than half our health care sector.

There is some truth in the suggestion that in Australia, you can build your own index fund, however you might want to build something different!

So how did we get here? It is tempting to blame the ACCC for allowing too many mergers, the FIRB for letting too many foreigners buy our companies and the government for not supporting home-grown global champions. The real reason is we operate in a global world, which makes it harder for many local companies to grow when competing against global super brands. Our country is rich in natural resources, therefore we do have a large resource sector like Canada. Our large banking sector is due in part to Australian households’ love of property debt and our failure to foster a deep corporate bond market.

Unfortunately, a highly concentrated sharemarket means more of your (future) retirement quality by default is linked to the fortunes of just a few sectors and companies. You’re not alone, as so is government revenue and maybe so your job, which creates a compounding wealth sensitivity.

Our markets defensiveness

Our situation in Australia is even more concerning, as about 80% of the index or broad market is made up of companies not traditionally considered “defensive” (not to be confused with military defence, which we also don’t have much of either). Defensive sectors are industries that are expected to perform better in down markets and include consumer staples, healthcare, telecommunications and utilities. This is exactly what has been happening in Australian markets over the last two years, as shown by the large arrows in Figure 3. If there is a mixing tap labelled growth and defensive at either end, it’s turned to defensive right now.

Figure 3: Growth of $1 invested in various Australian industry sectors since June 2000 (including reinvested dividends)

In Australia, defensive stocks make up only about 20% of the Australian sharemarket, ranking us third after Canada and Korea for having the least defensive sharemarket, as shown in the left side of Figure 4. This partly explains why the Australian sharemarket is more volatile than other markets like the US, UK, Switzerland, Japan and even Canada (the latter being much more integrated with the US economy). This is quantified in the right hand side of Figure 4, which shows Australia’s market “beta” or the extent to which changes in the US market are amplified in the Australian market. Our market outperformed pre-2007 and has underperformed since due to our high exposure to resources and banks.

Figure 4: Percentage make-up of defensive stocks among top 10 world stockmarkets and their relative market beta versus US S&P500
Investor response

Put bluntly, you wouldn’t design a market like ours from scratch and so you shouldn’t choose to invest solely using the index as your guide.
Instead consider:

• Surrounding a core index fund holding with satellites or tilts to sectors other than bank and resources;
• Introducing value or profit-weighted, index-type funds which, among other features, have lower resource company holdings;
• Adding an allocation of small companies to your portfolio (but make sure you don’t just load up on small miners with one mine, one mineral and one hope);
• Investing in currency-hedged international share index funds to dilute your Australian biases and get exposures to other sectors (or without hedging to be rewarded when the Australian dollar falls, often when resource stocks do);
• Favouring high-yield dividend funds that offer greater industry diversification over those that just load up on bank shares;
• Investing in ETFs which give you complementary sector exposure like iShares’ global consumer staples (IXI), health care (IXJ) and telecommunications (IXP);
• Introducing an overweight utilities exposure as discussed recently;
• Building your own more balanced industry sector portfolio; or
• Waiting for new ETFs offering different portfolio constructions, as outlined below.

Alternate portfolio constructions

Earlier, I suggested the merits of an INFLATION ETF™¢, which I have yet to hear any interest in. Undeterred, I suggest here two new products to add to the imaginary Professional Wealth® ETF series:
1. DEFENSIVE™¢ ETF (proposed ASX symbol “DEFEND”) – a portfolio of shares containing only defensive stocks, expected to at least fall less in a falling market but understandably rise less in a rising market; and
2. REBALANCED ALLORDS™¢ ETF (proposed ASX symbol “REMIX”) – a rebalanced All Ordinaries index, with half allocated to defensive shares and half to banks and cyclical stocks, perfectly suited for our market going up half the time and down the other half.

In Figure 5, the total dividend and price return from these two funds since 2005 is compared with that of the ASX200. You can see that while DEFENSIVE lagged in performance in the run-up to 2007, it fell less in 2009 and would have risen since to an all-time high, beating the returns from the ASX200. You can also see that a remixed REBALANCED ALLORDS or equal defensive/growth-constructed portfolio provides a reasonable in-between result, also beating the broader market index.

Figure 5: Growth of $1 invested in an all-defensives portfolio and a rebalanced All Ordinaries index versus the ASX200 (including dividend reinvestment)

Note in this chart the defensive portfolio is made up of 25% each from returns of the consumer staples, utilities, health care and telecommunications sectors, rebalanced semi-annually. The re-mixed All Ordinaries portfolio is 50% of that plus 10% each of financials, materials, energy, industrials and consumer discretionary. The IT sector was left out owing to its immateriality (with apologises to Computershare).

Note I have left out real estate investment trusts (REITs) from this discussion, not because I don’t recommend an exposure, but because they are a different or alternative asset class and should be introduced into your portfolio separately, alongside other asset classes like bonds and cash. Depending on the index fund, these are or aren’t included. The returns from REITs since 2000 were between industrials and telcos (Telstra) in Figure 3 and have been reasonable of late. Note also I remain uninterested in hybrid securities and also don’t include them.

If your local supermarket was like the Australian sharemarket, then perhaps aisles 1-7 would be energy drinks and 8-10 meat and veg. Here I simply want to suggest you go shopping with a list, rather than be tempted to put one thing from each aisle into your share basket.

Dr Doug Turek is Managing Director of family wealth advisory and money management firm Professional Wealth.