Could enhanced indexation help you manage geopolitical and concentration risk while capturing growth potential? By Anthony D’Silva, senior quantitative investment manager, Aberdeen Investments.
For professional investors only – not for use by retail investors or advisers.
For local government pension scheme (LGPS) investors, the debate around equity exposure has shifted amid heightened geopolitical and concentration risk.
It is no longer just about how much equity risk to run, but how that risk is structured – and what hidden assumptions sit inside long‑standing benchmarks.
Market‑capitalisation weighted indices have served schemes well. They are liquid, transparent and cheap to implement. That said, they’re highly exposed to ever-evolving geopolitical headwinds, and what’s more, given the dominance of a handful of very large US technology stocks, global market‑cap benchmarks have become increasingly concentrated.
For schemes such as LGPS, with long‑term horizons, that raises a simple question – how comfortable are you with an increasing reliance on a narrow group of companies to deliver equity returns from key growth themes such as artificial intelligence (AI), where the story remains strong but uncertain?
Equal weighting: simple, effective – but not neutral
Equal‑weighted indices are often proposed as a practical response. By allocating the same weight to each index constituent, they mechanically reduce exposure to mega‑cap stocks and rebalance portfolios towards the broader market.
For LGPS investors concerned about dependence on the so-called ‘Magnificent Seven’, this approach offers an intuitive way to dilute concentration risk without abandoning passive equity exposure altogether.
But equal weighting is not a free lunch. It changes the character of the portfolio in ways that matter for long‑term investors.
In practice, equal‑weight strategies tilt portfolios away from the largest companies and towards smaller ones. That shift brings with it clear factor exposures: greater emphasis on value and income characteristics, and higher sensitivity to smaller, more volatile stocks. These are not incidental effects – they are structural consequences of the methodology.
For some schemes, those tilts may be desirable. For others, they may introduce risks that need to be consciously managed.
The key point is that equal weighting replaces one set of embedded assumptions with another. It reduces concentration, but it does so by introducing systematic factor bets that should be acknowledged rather than assumed away. Furthermore, an equal weighting strategy can’t avoid unintended macro and geopolitical risk.
Turnover is another consideration. Equal‑weighted indices require more frequent rebalancing as prices move, which can increase trading activity and costs. For large LGPS pools, where scale and capacity matter, this is not trivial.
Enhanced indices: from implicit bets to intentional design
The more fundamental issue for LGPS investors is that benchmark choice is never neutral. Whether a portfolio tracks a market‑cap or equal‑weighted index, it is already making active decisions about size, style and factor exposure. The difference lies in whether those decisions are implicit or deliberate.
This is where enhanced indices become relevant. Rather than switching wholesale between benchmark methodologies, an enhanced index approach starts with a familiar market‑cap benchmark and then applies systematic, rules‑based tilts to address specific concerns – such as concentration risk or factor balance – while keeping risk tightly controlled.
In today’s market, that might mean modestly reducing exposure to the most crowded mega‑cap names and increasing exposure to underrepresented factors such as value, quality or diversified momentum. Crucially, these adjustments are made within clearly defined constraints on tracking error, turnover and cost.
This approach offers a pragmatic middle ground for pension schemes. It preserves many of the advantages of index investing – transparency, scalability and cost discipline – while allowing portfolios to evolve as market structure changes.
It also means schemes need not miss out on capturing potential growth. Factor-based enhanced indexation means it’s possible to retain momentum exposure despite reducing the overweight to larger companies.
Reducing reliance without making big calls
Perhaps the most attractive feature of an enhanced index approach is that it avoids binary decisions. Rather than making a blunt call on whether mega‑cap technology will underperform, the portfolio is structured to be less dependent on any single outcome.
If market leadership broadens, the portfolio is positioned to participate. If concentration persists, exposure remains – but at a more measured level. The result is equity exposure that is more balanced by design and more resilient across different market regimes.
For LGPS investors managing long‑dated liabilities, that matters. The objective is not to predict the next market cycle, but to build portfolios that can weather different outcomes without becoming overly reliant on a narrow set of drivers.
Quantitative methods
Enhanced index managers use quantitative methods to manage risk dynamically by embedding risk measurement directly into the portfolio construction process. Insight from a well‑resourced and experienced macro team informs targeted stress tests and economic scenarios, which can be mapped to individual stocks in the index.
Alongside this, proprietary quantitative factors are designed to capture macro, geopolitical and thematic sensitivities at the stock level, allowing managers to see how risks build and shift through time. This framework enables continuous monitoring of exposure to potential shocks – such as tariffs, conflicts or oil price movements – and supports timely portfolio adjustments with the objective of enhancing resilience and avoiding unintended risk concentrations.
Final thoughts
At the heart of every equity portfolio lies an important decision – how to weight the stocks it contains. Market-cap weighted indices are cost-efficient and liquid, but vulnerable to geopolitical and concentration risk. Equal weighting benchmarks have the potential to solve the concentration problem, but they embed hidden biases and higher turnover. A factor-based enhanced index approach can help reduce the concentration of mega caps in your LGPS portfolio and manage dynamic risks, without sacrificing all-important cost-efficiency and market growth exposure.
Next steps
To find out more about Enhanced Index investing with Aberdeen Investments, contact one of our team or visit our website.
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.
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