The dangers of following the herd

Announced in the King’s speech on 17 July, the new Pension Schemes Bill came as something of a surprise to industry commentators. Amongst other things, the bill aims to encourage market consolidation, whilst focusing on value and outcomes for members. Key to this—in the new government’s eyes at least—is the need to address the disparity in investment performance across the UK’s pension providers. 

This is of course positive—poor investment performance can have a devastating impact on a member’s retirement prospects. However, as a leading investment-led master trust, we’d perhaps frame the issue differently. Yes, risk-adjusted investment performance varies dramatically between the top-performing and worst-performing master trusts, but there are also clusters of providers delivering very similar results.¹ Why is this? We believe it has something to do with an overreliance on passive investment products, which tend to be exposed to high levels of concentration risk at the company, sector and country level.² As master trusts continue funnelling their members’ savings into these products, the risk of underperformance increases. So, too, do the systemic risks associated with investor crowding. 

In this commentary—the first in a series—we’ll look in detail at some of these risks. If the Pension Schemes Bill succeeds in concentrating UK pension assets into the hands of fewer providers, and definitions of ‘value’ continue to focus on costs above all else, then concentration risk will become all the more pronounced. 
 

Recap: What is concentration risk and investor crowding?

• Concentration risk refers to the potential for significant losses, which may occur when a large proportion of a portfolio is invested in a single asset or small group of assets.  

  A portfolio that is too concentrated tends to be more volatile, as performance—whether good or bad—is determined by just a few investments. What’s more, concentration risk can contribute to systemic risk if many investors are concentrated in the same assets. 
   

• Investor crowding occurs when a large number of investors chase high returns by piling into the same investment or strategy, often in response to market trends and signals. 
  
  This kind of behaviour can create price inflation (when the price associated with a particular asset rises to unsustainable levels), liquidity risk (particularly if many investors try to exit their positions simultaneously, causing prices to drop), and market inefficiencies (when the price of a particular asset no longer reflects its intrinsic value).    

The diversification myth

Concentration risk and the S&P 500 

Passive funds track an index. This means that by design, a passive fund tracking a market cap-weighted index—such as the S&P 500—will be exposed to very high levels of concentration risk. Put simply, the top-10 largest stocks in the S&P 500 represent a significant proportion of the overall index. 

Perhaps more alarming is how this has changed over the last 50 years. Chart 1 shows the top 10 largest stocks as a percentage of the S&P 500 from 1972 to the present day. What’s obvious is that we’ve surpassed previous highs—those top 10 stocks have more sway now than ever before. 

Chart 1: Today, the top 10 stocks account for over 35% of the S&P 500  

Source: SEI, using data from Ned David Research (NDR) and S&P Global. The chart shows the top 10 largest stocks in the S&P 500, as a percentage of the total S&P 500 capitalisation. As at 30 June 2024.

This can’t go on forever.  At some point, valuations will take a tumble, and those overly exposed to the S&P 500 will likely experience losses. For investors using passive funds to track the S&P 500, these losses could be significant. An active manager might be able to adjust their portfolio’s exposure to mitigate against losses—a passive manager is not afforded this luxury. 

A final chart to illustrate what we’ve been talking to—namely, that market cap-weighted indices, and by extension the funds tracking them, aren’t as diverse as you might think.

Chart 2 provides a country-level breakdown of MSCI World—an index tracking the performance of c.1, 500 large and mid-cap stocks across 23 developed countries. What’s stark is that the US now accounts for nearly three-quarters of the overall index, with the ten largest US stocks representing almost a quarter of this.

Chart 2: MSCI World is significantly weighted towards US stocks

Source: SEI, using data from MSCI. As at 30 June 2024.

So whilst a passive fund tracking MSCI World might sound diverse, in reality such funds are skewed towards the US and, in particular, the ten largest US stocks. 

What does this mean for definitions of ‘value’? 

It’s worth reflecting on what the above means for DC members, who often have very little say in how their hard-earned savings are invested by their pension provider. Passive funds are not as diverse as they appear—even those tracking global indices are highly concentrated. And if this much goes unacknowledged, then we’re leaving an increasingly large number of members exposed to potential loss, which could negatively impact their standard of living in retirement. 

This gets to the crux of the matter: in encouraging market consolidation, the Regulator needs to think seriously about what constitutes ‘value for money’. Yes, the fees associated with passive funds are attractive, but given the risks we’ve outlined in this post, do passive funds really offer value? Wouldn’t members be better served if instead of fees and fees alone, those tasked with making investment decisions on their behalf focused on helping to protect their retirement outcomes? This, after all, is the reason people have a pension. And if ensuring members are adequately provided for in retirement is our ultimate goal, then any definition of value needs to take stock of this. 

¹As an example, see CapaData, ‘Risk/Return—younger saver, 30 years from retirement, 1-year, 3-year, 5-year annualised’, Corporate Adviser, Q4 2023.

²Alex Toney, Hugo Gravell, ‘DC governed default investment strategy insights 2024’, Barnett Waddingham, 29 April 2024.

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