Bank, property sector pain turns spotlight on portfolio concentration risk
Concentration risk is an insidious portfolio condition, brought on by having too much exposure to individual companies or sectors.
The share prices of Australia’s major banks and listed real estate investment trusts have been pummelled in recent weeks, leaving millions of investors feeling the ill effects of concentration risk.
Concentration risk is an insidious portfolio condition, brought on by having too much exposure to individual companies or market sectors.
And it can be totally avoided with good investment planning, to mitigate risks through a strategic asset allocation strategy.
But the COVID-19 pandemic is highlighting the structural weaknesses in many investment portfolios that been heavily tilted towards banks and property companies.
While other sectors, including aviation, travel and hospitality, also have been hit hard by recent events, the reality is that a much higher percentage of equity investors have a heavy bias towards banks and commercial property because of their dividend streams.
The big problem is that those dividend streams are now under serious threat of being constricted or blocked as the wider repercussions of the coronavirus flow through to all segments of the economy.
On average, the companies within the banking and financial sector and those within the commercial property sector have lost between 30 per cent and 50 per cent of their value since late February. That compares with the 27 per cent fall of the broader S&P/ASX 300 index over the same period (as at April 9).
The share prices of the “big four” major banks — Commonwealth Bank, Westpac, National Australia Bank and ANZ — have fallen 30-40 per cent over less than two months.
Their shares are among the most widely held securities in Australian portfolios, and these four companies represent almost a third of the total value of the domestic market.
There are now widespread expectations that all banks will suffer a sharp decline in revenues and earnings, and probably will experience a spike in bad and doubtful debts, as individuals and businesses struggle with the financial fallout emanating from the COVID-19 outbreak.
For bank shareholders, along with the plunge in the share prices is a strong likelihood of a cut to dividend payouts when they announce their interim earnings results this month. (NAB cut its dividend by two-thirds this week). The potential for cutting dividend income to shareholders has sparked further falls in bank share prices.
Systemic risks associated with COVID-19 are also flowing across the commercial property sector.
Like the banks, listed property companies, otherwise known as Australian real estate investment trusts (A-REITS), have seen their share prices plunge since February. As a whole, the A-REITS sector — which encompasses the owners of shopping centres, office buildings, industrial sites and large-scale residential developers — is down more than 40 per cent.
Listed property companies have been hit especially hard as a result of the sudden closures of tens of thousands of big, medium and small businesses across Australia because of the current operating restrictions stemming from social distancing laws.
There are also numerous government measures now in place enabling tenants to seek reductions or deferrals in their rent, which for some property companies is causing cash flow issues.
These measures are flowing through to A-REITS revenues and earnings, and potentially to dividends.
Concentration risk comes in different forms, from having an overweight exposure to specific companies and sectors, to having too much of a portfolio exposed to the domestic market (also known as home bias).
It can also arise as a result of stock-picking strategies, where an investor chooses companies randomly on the basis of capital growth or dividend income expectations. The end result can be a poorly constructed portfolio that has large overlaps, because many of the companies chosen fall into the same industry.
When a systemic problem arises, such as those occurring with banks and property companies, overexposed investors stand to record bigger losses than those with wider equity allocations.
Mitigating concentration risk is about having a much greater awareness of asset allocation strategies to reduce exposure to company and sector-specific issues, and to smooth out volatile trading conditions.
Diversified index funds, such as managed funds and exchange traded funds with wide-ranging holdings across one market or multiple markets, are prime vehicles for achieving this.
Tony Kaye is senior personal finance writer at Vanguard.
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