The investing industry is constantly devising new acronyms and buzzwords. Sometimes these can be dangerous. The rise of the FANG stocks highlights how clusters of stocks may create investing hazards that standard risk models struggle to detect.

Equity investors rely on various risk models to protect portfolios from a range of threats. Standard models generally focus on factors that affect performance, such as style, sector, country and currency. These models are designed to make sure that an investor is aware of a portfolio’s exposures and can avoid being too heavily tied to particular areas of the market.

But fundamental risk models track only a defined set of risks. There are countless hazards to investing portfolios that slip under their radar screens. In particular, we think investors should pay more attention to cluster risk. This is the risk that performance patterns of a group of stocks with similar business profiles but different risk classifications become correlated.

RISE OF THE FANGS

US mega-cap technology stocks are an excellent example. Over the past two years, Facebook, Amazon.com, Netflix and Google have become known collectively as the FANG stocks, a group of companies dominating the transformation of media and consumer markets through technology. More recently, Apple has been added to the group, which is now known as the FAANGs.

These companies have a combined market cap of $2.6 trillion, or nearly 11% of the S&P 500 Index market capitalization. From January 1 through August 31, they accounted for more than a quarter of the S&P 500’s gains. And they’ve generated ongoing debate about whether a bubble is developing in technology stocks.

This is where the problems begin. Although technology drives the businesses of all five companies, they aren’t all classified as technology stocks by risk models. According to MSCI’s Global Industry Classification Standard (GICS), Facebook, Google and Apple are information technology companies, while Amazon.com and Netflix are in the consumer-discretionary sector.

UNINTENDED RISKS MATTER

Taxonomy is more than just a technicality. Standard risk models might check that a portfolio doesn’t have too much exposure to the technology sector or the consumer sector. But they don’t look at the FANG or FAANG groups as a whole. And if the performance of these stocks is correlated, a portfolio that holds too much of the group might face unwanted risks.

In fact, we believe the group’s stock returns have become increasingly correlated. Over the past two years, the term “FANG” became popularized, as indicated by Google trends search data (Display, left). Meanwhile, stock-specific returns for the group have increasingly moved in step (Display, right). We calculate stock-specific returns by taking the stock’s actual return and subtracting the influence of factor returns.