A Tale of Two Markets

Market Concentration and the COVID-19 Recovery

Ian Tam, CFA 25 August, 2020 | 1:14AM
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US-Canadian Dollars

Well, that was quick. Despite bleak global economic outlook and the continued uncertainty brought on by the coronavirus pandemic, as of August 6, 2020, the U.S. market recovered to its pre-pandemic high.

Using the concept of the “pain index” coined by my colleague Dr. Paul Kaplan, the COVID-19 bear market goes down in history as one of the least painful on record, lasting a total of about 120 trading days with a maximum drawdown of about 34%.

Exhibit 1

Source: Morningstar Direct | Data as of August 7, 2020

We could endlessly speculate on the reasons behind the recovery; however, it might be more productive to glean some concrete insights on its nature. To begin with, a quick look at the holdings of the SPDR® S&P 500 ETF Trust shows us that the S&P 500 is concentrated.

Exhibit 2
Source: Morningstar Direct | Data as of August 7, 2020

The broad market index long known as a representation of the U.S. economy is somewhat concentrated on the five FAANG-type companies (if we count Google’s Alphabet as one entity), each of which has performed exceedingly well during the pandemic.

To understand to what extent these five names contributed to the index returns in this recovery, I ran a simulation of the S&P 500 index without them. To do this, I leveraged the Morningstar® CPMS™ back testing engine by replicating a market-cap weighted portfolio of 494 companies, specifically excluding the five largest companies (including both share classes of Alphabet Inc) staring January 31, 2020. The parameters of the test included a calendar quarter re-balance at the end of March and June back to target weights with all dividends being re-invested to mimic the index.

Exhibit 3

Source: Morningstar CPMS

Let’s look at what that means in dollar terms.

Exhibit 4
Source: Morningstar CPMS

The outcome of the test shows that without the five largest companies, the S&P 500 index would still have recovered to peak or near-peak levels but would have been a full 6% lower in value at the end of July, assuming a common investment start date of January 31, 2020. Although the market recovery can’t be attributed solely to the success of the FAANG-type stocks, these stocks certainly played a critical role in the recovery so far.

Oh Canada

For Canadian stock investors, the recovery hasn’t been quite as boisterous. As of August 17, 2020, the S&P/TSX Composite benchmark index is roughly 6% shy of its pre-pandemic highs.

Exhibit 5
Source: Morningstar Direct | Data as of August 17, 2020

Like in the U.S., the S&P/TSX Composite Index also has 25% of its weighting in five companies, four of which have been around for at least 50 years. The fact that their performance (Shopify excepted) has been far from exceptional might explain why the Canadian market hasn’t quite recovered. Moreover, as the sixth largest energy producer in the world, over 10% of Canada’s GDP stems from the energy sector, which represents 13% in terms of weight of the benchmark index. Unfortunately, the pandemic brought with it a reduction in demand for energy which ultimately led to depressed oil prices.

To understand the extent of this impact, I ran a similar study as I did for the U.S. market, but this time excluding the energy sector. On January 31, 2020, the simulated portfolio bought 197 stocks on a market-float weighted basis and was re-balanced to target weights on calendar quarter ends (once at the end of March, and again in June) with dividends re-invested.

Exhibit 6

Source: Morningstar CPMS

Here’s what this looks like in dollar terms

Exhibit 6-2
Source: Morningstar CPMS

Without exposure to the energy sector, the index would have recovered back to pre-pandemic levels by the end of July. In other words, having exposure to the energy sector detracted  6.2% from the index performance.

Why Market Concentration is a Bad Thing
In the case of the U.S. Market, having concentration in the top five names has helped performance during the recovery period of the pandemic. But Canada’s concentration in Energy has detracted from its performance.

Investors with a mix of passive index ETFs, active funds, and individual stocks may unknowingly be over-exposed to a particular sector, or worse yet, a particular name. Single stock (or unsystematic risk) is caused by this very issue and can easily be taken care of by ensuring that you have a well-diversified portfolio. For Canadians in particular not doing so has proven to be catastrophic in the past and is something all investors want to keep an eye on, especially during fast-moving markets.

This article does not constitute financial advice. It is always recommended to speak to an advisor or financial professional before investing.


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About Author

Ian Tam, CFA  is Investment Specialist at Morningstar Canada. 


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