We have touched before on the issue of ‘concentration risk’ or having too many eggs in one basket and the benefits of a diversified portfolio. The recent decision by the Nasdaq stock exchange to reduce the weighting of the biggest tech stocks has once again raised the question, can you have too much of a good thing?

We do not necessarily mean tech stocks, but as an investor it is important to know how much exposure you have to each area of the market.

In terms of diversification, funds and investments trusts can be a smart way to spread risk in a portfolio, but is it possible that without realising it you can still end up with more exposure to some parts of the market than you bargained for?

X-RAY YOUR PORTFOLIO

The good news is help is at hand in the form of tools like the ‘portfolio x-ray analysis’, which is free for customers of financial services firm AJ Bell, the owner of Shares magazine.

The ‘x-ray’ tool, powered by Morningstar software, not only calculates the spread of your investments in individual stocks but can ‘look into’ trusts, funds and ETFs (exchange-traded funds) and work out your exposure from the list of their holdings to give you a full picture.

Below is an analysis of a theoretical portfolio showing both the underlying sector exposure as well as the stylistic ‘tilt’ towards cyclical, defensive and economically sensitive businesses.

In this case, the portfolio is well balanced between diverse types of businesses, albeit the underlying sector weightings are vastly different from say the FTSE 100 or the FTSE All-Share index.

AJ BELL PORTFOLIO X-RAY ANALYSIS

TOP MANAGERS MAKE BIG BETS

As American market guru and writer Howard Marks often reminds us in his investor letters, if you want to beat the market you have to do something different to the market.

As investors it is our job ‘to intelligently bear risk for profit - doing it well is what separates the best from the rest,’ says Marks.

Taking concentrated bets – and by association greater risk – is one way to generate better returns than the market, assuming you can identify great companies and buy them well.

If we look at Fundsmith Equity (B41YBW71), one of the largest and most widely owned funds among retail investors, the portfolio is made up of just 26 holdings with a strong bias towards consumer stocks and healthcare, and little exposure to technology or financial companies.

The firm lists its top 10 stocks on its website but does not reveal their weightings or tell us how much of the portfolio they make up, just that they are ‘high quality, resilient, global growth companies that are good value and which we intend to hold for a long time’.

However, Morningstar reports that as of the end of May the top five holdings – Microsoft (MSFT:NASDAQ), Novo Nordisk (NOVO-B:CPH), L’Oréal (OR:EPA), LVMH (MS:EPA) and Philip Morris International (PM:NYSE) – accounted for exactly a third of the portfolio, so it would seem a reasonable guess that the top 10 account for more than half the fund.

This level of concentration takes a lot of skill on the part of the managers and a lot of faith on the part of investors, but yet again Terry Smith has shown he knows his onions as his second-largest holding, Danish drugmaker Novo Nordisk, has rocketed recently following positive trial data for its Wegovy obesity treatment.

Just as important as knowing which individual stocks drive returns, investors should understand the sector weightings in the funds they own, which is easy enough as most provide a breakdown in their monthly fact sheets.

In the case of Fundsmith Equity, its sector exposure is vastly different to the MSCI World Index which the fund uses as its equity benchmark, with nearly 45% of its holdings in consumer sectors against less than 20% for the index, nearly 25% in health care against less than 12% for the index and just under 10% in technology against nearly 22% for the index.

It is a similar story with Lindsell Train Global Equity (B18B9X7), another extremely popular fund which makes concentrated bets.

Its top 10 holdings comprised just over 60% of the portfolio at the end of July and like Fundsmith Equity it has a very high weighting in consumer stocks compared with the index.

It also has more exposure than the index to media and communications services stocks including Anglo-Dutch firm RELX (REL) which is the fifth-largest holding in the portfolio.

HOW DO OTHER POPULAR FUNDS COMPARE?

We have done the same exercise for three of the most popular investment trusts, Scottish Mortgage (SMT), managed by Edinburgh-based Baillie Gifford, JP Morgan Growth & Income (JGGI) and City of London (CTY), managed by Janus Henderson.

Scottish Mortgage is less concentrated than the two open-ended funds, with the top 10 stocks making up just over 44% of the portfolio as of the end of June according to the company.

However, it is highly focused in terms of sector bets with close to a 40% weighting in consumer names, close to 30% in technology names and no exposure at all to financial, industrial, basic material, energy, utility or real estate stocks.

JP Morgan Global Growth & Income is less concentrated again in terms of top 10 holdings which make up just 34% of the portfolio, and its sector weightings are the closest to those of the MSCI World albeit with an underweight position in health care, industrial and communications stocks and no exposure to basic materials or real estate.

City of London has a similar level of concentration with its top 10 stocks, but is the odd one out in other respects, most noticeably by having no exposure whatsoever to the technology sector and being overweight financial and energy stocks as well as consumer companies.

WHAT IF I OWN ALL FIVE?

If you held each of the five funds we have analysed in equal amounts, what would your exposure look like relative to the index and would you have ‘too much of a good thing’?

Looking at the sector weightings of all five, the most obvious differences would be in the level of exposure to consumer and technology stocks.

We estimate the weighting to consumer stocks, both staples and discretionary, would be around 34% compared with the MSCI ACWI (All-Country World Index) weighting of 18.6%, while technology would weigh in at just 12.3% against 21.9% for the index.

This might sound like a risky bet given how well technology stocks have been performing, but it’s a case of chicken and egg – the reason the weighting of tech stocks in the index is so high is precisely because they have rallied so much this year, so trying to chase them now by overweighting them could be more risky than being underweight.

In most other respects, an equally-weighted portfolio of the five funds actually does a reasonably good job in terms of replicating the index weights when it comes to financial, health care and communication stocks, but it underweights industrials, energy and basic materials which are more cyclical in nature and which in any case will struggle in a low-growth environment.

We have not looked at the country exposure of all five funds, but apart from City of London, which invests solely in the UK, the rest have similar geographic weightings to the index, mostly through their technology, consumer and financial holdings which are predominantly US stocks.

For investors who want to explore this aspect of their holdings, each fund gives its geographic exposure on its corporate website.

DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. The author of this article (Ian Conway) and the editor (Tom Sieber) own shares in AJ Bell.

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