How to gain diversification in concentrated markets

The Australian stock market is one of the most concentrated in the world with the top 10 stocks making up ~45% of the S&P/ASX 200. At a sector level it is even more concentrated.

Most investors are familiar with the concept of diversification. We know that if we put all our eggs in one basket our returns will experience high volatility, but if we spread our investments across several different assets we’ll reduce the volatility of returns. In fact, diversification is such a key component of share investing that the Cambridge Dictionary even refers to the stock market in their definition of ‘diversify’: People are advised to diversify their investments in the stock market to reduce risk.

So how do you improve diversification when investing in a highly concentrated sector?

The answer is capping the weight to individual stocks.

As an example, we can take a look at the A-REITs (listed real estate investment trusts) sector in Australia and compare the S&P/ASX 200 A-REIT Index which is weighted by market cap and the MVIS Australia A-REITs Index which caps individual stock weights at 10% on rebalance¹.

S&P/ASX 200 A-REIT Index			MVIS Australia A-REITs Index
Security Name	Index Weight (%)		Security Name		Index Weight (%)
Goodman Group	26.17%		Goodman Group		11.93%
Scentre Group	10.87%		GPT Group		10.26%
Dexus	9.97%		Dexus		10.09%
Mirvac Group	8.43%		Mirvac Group		9.35%
GPT Group	8.20%		Stockland		9.02%
Stockland	7.72%		Scentre Group		8.75%
Vicinity Centres	5.33%		Vicinity Centres		8.54%
Charter Hall Group	4.63%		Charter Hall Group		8.38%
SCA Property Group	2.35%		BWP Trust		4.79%
BWP Trust	1.97%		SCA Property Group		4.78%
Charter Hall Long Wale REIT	1.95%		Charter Hall Long Wale REIT		4.63%
Waypoint REIT	1.92%		Cromwell Property Group		3.55%
National Storage REIT	1.89%		National Storage REIT		3.47%
Cromwell Property Group	1.67%		Abacus Property Group		2.44%
Charter Hall Retail	1.58%
Ingenia Communities	1.25%
Centuria Industrial	1.10%
Unibail-Rodamco-Westfield	1.05%
Abacus Property Group	0.98%
Growthpoint Properties	0.98%

We have calculated the Herfindahl index for both indices. The Herfindahl index is a commonly used measure of market concentration. The lower the Herfindahl index, the better as a lower index number signifies less concentration and greater diversification.



As you can see above, the MVIS Australia A-REITs Index has a lower Herfindahl index than the S&P/ASX 200 A-REIT Index even though it only includes 14 A-REITs compared to 20 in the market cap weighted S&P/ASX 200 A-REIT Index. It has a lower Herfindahl index and less concentration and greater diversification as a result of the stock weightings being capped at 10%.

Capping of stock weights helps reduce concentration risk and improve diversification in highly concentrated markets and sub-sectors.



1. Indexes are rebalanced at regular intervals to update constituents at which time weightings are also reset in accordance with the index rules. The MVIS Australia A-REITs Index is rebalanced quarterly. Outside those dates market movements result in weighting changes, which may include above the cap.