The curse of having to invest in large caps
Take a look at the table below. It shows the top holdings of three active global equity funds sold in the UK. All three funds have great track records, are quite active (not index huggers) and are huge in size (many billions in AUM). While the funds have different investment approaches their top holdings show a striking similarity with many names identical across the funds.
Top holdings of three global equity funds
Source: Morningstar
Nobody should be surprised to see a similar set of stocks in the top holdings of any active fund. Active fund managers are forced to buy the largest companies in their investment universe and hold them just to keep the risk of their portfolios relative to the benchmark under control and within acceptable limits. How much risk relative to the benchmark a manager is willing to take differs from person to person and form asset manager to asset manager, but inevitably, the largest companies in the index will take up a lot of space in the portfolio.
Now think back about the good old times of the bull market of the 2010s. Companies like Apple or Microsoft where outperforming most other companies. That meant that these companies over time became bigger holdings in the portfolio of these and indeed all actively managed funds that owned these stocks. And that means that after a while, the fund manger may hit allocation limits or decide she needs to sell some of these holdings to rebalance the portfolio.
But if that happens to one fund manager, it likely happens to other fund managers as well. The result is that when it comes to these large caps, when they had a good run, they start to experience selling pressure from active fund managers trying to rebalance their portfolios.
And it’s not just active fund managers that feel the need to sell, passive funds that don’t follow a simple market cap weighted strategy have the same issue. If you are running an equal weighted portfolio or a portfolio that is weighted by dividend (as some dividend ETFs do) or any other fancy weighting scheme, a strong run in a large cap stock can create a need to rebalance.
But rebalancing is only a small transaction. How much can that influence the share price of these large companies? If we trust the research of Huaizhi Chen from the University of Notre Dame, then the selling pressure from the many active funds holding these large caps amounts to a significant shift in returns.
Looking at the quarterly holdings of US mutual funds and the price action of the largest stocks in the US over the quarter, Chen was able to calculate the selling pressure from actively managed funds and track the return of these stocks in the following quarter. When a stock increases its portfolio weight by 1% as a result of strong returns, the fund manager is some 20% more likely to sell the stock and 14% less likely to buy the stock in the following quarter.
This results in lower returns for these stocks in the first half of the subsequent quarter. The 20% stocks with the highest selling pressure have returns that are 0.45% lower in the first half of the subsequent quarter than what could be expected given their valuation, size, and systematic risk. To be fair, these stocks still tend to have positive returns in that period, but that returns is about one percentage point lower than the 20% stocks with the lowest selling pressure.
Fund managers can do nothing about this effect. It is simply good risk management to limit the degree to which the portfolio deviates from the benchmark and the best and most liquid way to do that is to own some of the largest stock in the index. It is just because all the fund managers apply this sound risk management that the returns of high performing large caps stocks tend to get distorted as selling pressure from rebalancing mounts. It is the very nature of large cap and all cap funds that they have to accept this drag, while small- and mid-cap funds have it to a lesser degree or not at all.