What kind of stocks do you invest in? These days, a common answer to this question is simply ‘all of them’. For little cost, you can buy an exchange traded fund to own a broadly diversified equity market. Job done.
Well, sort of. If you own a FTSE 100 passive fund, you own a piece of every company in the index. But because the weighting of each constituent within the index depends on its market capitalisation, this creates a size factor bias. You own all of them, but the 20 largest – with all the attributes that typically come with very large, mature international businesses – make up most of what you own.
It’s a similar story elsewhere. The S&P 500 is heavily weighted to a few names, as well as ‘quality’ and ‘growth’ factors. The MSCI Germany index, designed to cover 85 per cent of Germany’s equity market, manages the feat across just 56 stocks, the 10 largest of which comprise three-fifths of its value. Boil things down further, and you’ll find that the balance of risk and reward from these companies is more driven by momentum and low-volatility factors than an equivalent global stock market benchmark (itself riddled with its own biases and tilts).
