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The only two acceptable reasons a fund should be underweight a stock

08 August 2024

Quilter Cheviot’s Nick Wood explains why funds may own a stock.

By Jonathan Jones,

Editor, Trustnet

Career risk has become an important factor in judging the performance of fund managers in recent years, with some potentially owning stocks to avoid losing out to their benchmark index, rather than because they have a high conviction in the company.

In the modern world of the ‘Magnificent Seven’, funds without some exposure to these names have been left behind, with much of the returns made by the US S&P 500 index and global MSCI World benchmark over the past few years coming down to a handful of names.

Indeed, Microsoft, Apple, Nvidia, Amazon, Alphabet and Meta (six of the seven) make up a combined 21.5% of the MSCI World index. Using the iShares Core S&P 500 UCITS ETF as a proxy for the S&P 500 weightings, this figure rises to 31% for the US benchmark.

Active managers are supposed to have high conviction in their holdings, meaning they should be overweight relative to the benchmark if they want to outperform.

As Nick Wood, head of fund research at Quilter Cheviot, put it, otherwise “if you are right on this stock, and you’re underweight, being right means you are going to underperform”.

Yet there are many instances where funds do own stocks at weightings below that of the benchmark. While some are transitory reasons – such as they are being sold in stages or where a position is being added to – there can be structural reasons too.

In fact, there are two circumstances – and only two – where Wood said it is acceptable to own a stock with a lower weighting than the index.

The first is that a fund is benchmark aware. Using the example of chipmaker Nvidia, he noted for a US manager, not owning Nvidia would have had a massive impact on a portfolio.

“Half of their tracking error and risk was in one stock. Now that is quite an extreme situation. Even in the UK, not owning the largest company will not get you to that number,” he said.

In this case, owning a stock at an underweight to make sure you do not lose out as much should the company flourish, is acceptable, he said.

The bigger issue comes with truly benchmark agnostic stockpickers. Here, Wood said why they are underweight is one of the most common questions he asks fund managers when reviewing whether or not to invest with them.

“It is a question we ask every fund manager: tell me about the underweight position because it makes no sense,” he said.

For this group, the only reason for it is based around position sizing and how risk-conscious they are. For example, if a manager has a set limit on the amount they are willing to invest in any one company.

In this scenario, should the manager have a 9% position in Nvidia to get a meaningful overweight position, or is this too much single-stock risk? They may say: ‘I don’t think any stock, regardless of my conviction, should be more than 5%’, he explained.

“Not all fund managers say that by any means but that is something I can understand,” said Wood.

However, he noted that “plenty” of managers bought into Nvidia after the stock’s “big pop” at the start of the year, with “some career risk potentially involved”.

Earlier this year, IBOSS chief investment officer Chris Metcalfe also noted how too many managers are worried about career risk.

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