FAANG stocks ex­pose a clus­ter-risk blind spot for funds

The Globe and Mail (BC Edition) - - GLOBE INVESTOR - COR­MAC MULLEN

The surge in FAANG stocks is ex­pos­ing a blind spot in fun­da­men­tal-risk mod­els that is largely over­looked by in­vestors and may en­dan­ger their port­fo­lios, ac­cord­ing to Al­lianceBern­stein.

Clus­ter risk, oc­cur­ring when per­for­mance pat­terns be­come cor­re­lated among a group of stocks with sim­i­lar busi­ness pro­files yet dif­fer­ent sec­tor clas­si­fi­ca­tions, is a haz­ard that can of­ten slip un­der a risk man­ager’s radar, AB’s David Dal­gas, Klaus Inge­mann and Thomas Chris­tensen wrote in a blog post.

Face­book Inc., Amazon.com Inc., Ap­ple Inc., Net­flix Inc. and Google owner Al­pha­bet Inc. – col­lec­tively known as the FAANGs – are a prime ex­am­ple, AB said. To­gether, the mega­cap stocks ac­counted for more than a quar­ter of the gains in the S&P 500 from the be­gin­ning of the year through Au­gust and have be­come in­creas­ingly cor­re­lated, ac­cord­ing to AB. How­ever only Face­book, Google and Ap­ple are clas­si­fied as tech­nol­ogy stocks un­der MSCI’s Global In­dus­try Clas­si­fi­ca­tion Stan­dard, while Amazon and Net­flix are seen as con­sumer-dis­cre­tionary shares.

This cre­ates a po­ten­tial prob­lem for risk man­agers, who would tend to mon­i­tor port­fo­lios so that they don’t have too much ex­po­sure to ei­ther the tech­nol­ogy sec­tor or the con­sumer sec­tor rather than look­ing for a cor­re­lated group of shares from dif­fer­ent in­dus­tries.

“A risk model that isn’t aware of this cor­re­la­tion may prompt a port­fo­lio man­ager to pur­chase all five FAANG stocks – a po­si­tion that could be vul­ner­a­ble to a sharp down­turn of the group,” ac­cord­ing to AB. “Or, the risk model may sug­gest adding to po­si­tions in Net­flix or Amazon.com with­out con­sid­er­ing the pos­si­bil­ity that these po­si­tions may suf­fer if Ap­ple has a bad day.”

Clus­ter risk can also arise in other sec­tors, such as fi­nan­cials and health care. Amer­i­can Ex­press Co. is clas­si­fied as a fi­nan­cial stock while fel­low credit-card peers Master­card Inc. and Visa Inc. are listed as tech­nol­ogy shares.

The so­lu­tion? In­vestors do not need to aban­don stan­dard risk mod­els, but should ap­ply “fun­da­men­tal logic” to their quan­ti­ta­tive pro­cesses, ac­cord­ing to AB.

DADO RUVIC/REUTERS

Face­book, Amazon.com, Ap­ple, Net­flix and Al­pha­bet are a prime ex­am­ple of mega­cap stocks that are vul­ner­a­ble to clus­ter risk, which oc­curs when per­for­mance pat­terns be­come cor­re­lated among a group of stocks with sim­i­lar busi­ness pro­files, yet dif­fer­ent sec­tor clas­si­fi­ca­tions.

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