The High Price of Low Volatility | U.S. Equity market commentary 2Q23
Oakmark is the mutual fund family launched in 1991 by Harris Associates, the Chicago deep-value firm founded in 1976 (about $105bn AUM). Bill Nygren runs the flagship Oakmark Fund and David Herro the Oakmark International Fund, buying businesses at large discounts to intrinsic value and holding them like owners — publishing quarterly fund commentaries, market commentaries and insight articles.
In plain words
This report challenges the common belief that index funds are low-risk. It points out that funds tracking the NASDAQ 100 or Russell 1000 Growth are heavily concentrated—Microsoft alone can be 13% of the portfolio. If those top stocks fall, the fund falls hard. In contrast, actively managed funds like Oakmark hold more diverse positions and actually lost less in the 2022 downturn, recovering faster. The report also warns that so-called 'low volatility' stocks are often expensive and slow-growing, making them a hidden risk. For everyday investors, the key takeaway is: don't assume index funds are safe—check what they actually own.
Oakmark's report, The High Cost of Low Volatility, highlights a divergence in how the investment community defines "risk": business owners focus on declines in business value, academia uses quantitative metrics like beta and standard deviation, and many fund managers view tracking error as key. The
Theme and Background
This section discusses the significant divergence in the investment community's definition of "risk" and challenges the market consensus that "index funds equal low risk." The author argues that market-cap-weighted index funds (such as the NASDAQ 100 and Russell 1000 Growth) actually carry severe concentration risk, potentially exceeding the risk level of actively managed funds.
Core Thesis
The author's central argument is: Index funds are not low-risk, and their concentration risk is widely overlooked by investors. Counterintuitive judgments include:
- Index funds tracking the NASDAQ 100 may need to be labeled as "non-diversified" funds by the SEC due to concentration issues.
- Many investors buy low-volatility stocks to reduce risk, only to take on valuation risk (paying high prices for low-growth companies).
- The Oakmark Fund's high tracking error (10.5%) does not equate to high risk; its actual downside protection is superior to the index (downside capture ratio of 94%).
Key Arguments and Data
1. Concentration Risk Comparison (presented in a table):
| Metric | NASDAQ 100 Index Fund | Oakmark Fund |
|---|---|---|
| Top 5 Holdings Weight | 47% | 15% |
| Largest Holding Weight | Microsoft 13% | Alphabet <4% |
| Largest Sector Weight | Technology 51% | Financials 38% |
| Total Weight of Holdings >5% | 47% | None (cap at 4%) |
2. Russell 1000 Growth Index Fund: Top 10 holdings account for over 50% of assets, the technology sector makes up 43%, and 37% of assets are invested in single holdings exceeding 5% — warranting a "non-diversified" warning. In contrast, the largest holding in the Russell 1000 Value Index (Berkshire Hathaway) is only 3%, and the top 10 account for just 17%.
Oakmark Fund Investor Class average annual total return data shows, as of June 30, 2023, a 1-year return of 27.11%, a 10-year return of 12.05%, a since-inception return of 12.55%, and an expense ratio of 0.89%.
3. S&P 500 Concentration: Top 10 holdings account for 31% (Oakmark Fund: 26%), with Apple at 7.7% and Microsoft at 6.8%. Yet, S&P 500 index funds are not required to disclose concentration risk warnings like Oakmark.
4. Drawdown and Recovery: From January 3, 2022, to October 12, 2022, the S&P 500 fell 24%, while the Oakmark Fund fell only 20%. As of the end of June 2023, the S&P was still 5% below its peak, whereas Oakmark had fully recovered.
5. Volatility Metric Changes: Oakmark Fund's three-year standard deviation rose from 17% to 22%, and beta increased from 0.7 to 1.1. Reasons include: low-volatility stocks becoming expensive (the author chose not to buy), and beta for value sectors (autos, financials, energy) rising over 40%.
6. Low-Volatility Stock Analysis: Among stocks with a market cap over $1 billion and volatility lower than the S&P 500, the author found none more attractive than their holdings — these stocks are mostly low-growth, high-P/E companies, yet their standard deviation has declined by 23% over 20 years.
Companies/Assets Involved
- Microsoft: Largest holding in NASDAQ 100 (13%), a source of concentration risk.
- Alphabet: Largest holding in Oakmark Fund (3.5%), deemed by the author to have the best risk-reward profile, with an active cap at 4%.
- Apple: Largest weight in S&P 500 (7.7%), a case study in index concentration.
- Tesla, Meta: Close to the 5% threshold in NASDAQ 100; a breach would trigger SEC restrictions and IRS tax risks.
- Berkshire Hathaway: Largest holding in Russell 1000 Value (3%), used as a diversification comparison case.
Investment Implications
- Beware of hidden concentration risk in index funds: Investors should not view market-cap-weighted index funds as low-risk tools, especially those with excessive technology sector weight (e.g., NASDAQ 100, Russell 1000 Growth).
- Actively managed funds may offer superior drawdown protection: The Oakmark Fund experienced a smaller decline and faster recovery during the 2022 bear market, proving that high tracking error does not equal high risk.
- Low-volatility strategies may harbor valuation traps: Current low-volatility stocks are generally expensive and offer mediocre growth, with investors paying a high premium for "smoother returns."
- Value investing requires accepting short-term volatility: The author explicitly chooses "attractive price + high volatility" over "expensive + low volatility" and expects the low-volatility premium to eventually fade.