Gravity Wells in Beta: Using Absolute Return to dial down Mass Effects
By JB Beckett, Author of New Fund Order, and Professor James Clunie, Director at Long-Short Consulting Limited.
Preface: Do large-scale indexation, Big Tech IPOs and oversized ETFs create measurable index “gravity” around the largest market capitalisation constituents? Likely, be that through inclusion premia, predictable rebalances and tracking‑error–driven allocation, which can support index beta but also raise concentrate stock and valuation risks. Through large AI companies, Private Equity is acting like a Pulsar upon entering a large-cap public index, distorting its gravity and the behaviour of trading flows around it. These effects are largely unavoidable and for some time it has rocketed Beta. Yet if ‘Spikeflation’ persists or market liquidity wanes then absolute‑return long/short funds can be useful to hedge tail-risk rising in these gravity wells.
Space, the final frontier Jim, especially for SpaceX if the valuations are to make some sense. Musk’s recent IPO and impending Big IPOs of OpenAI and Anthropic all test the normal behaviour of the large cap cosmos, particularly the US market where the gravity for assets is strongest. Their entry acts like a pulsar entering a solar system, a rapidly spinning neutron star. A pulsar’s mass and intense gravitational field would not only tug at planets but also distort the orbits of smaller bodies, bend the trajectories of passing comets, and create tidal stresses that rearrange debris into new patterns. Objects that once moved independently would begin to orbit the pulsar’s gravity well, their paths altered by a new, dominant mass. Just like Big Tech and AI, which have formed a concentrated mass of capital that bends the flow of investment.
The analogy. Think of these gravity wells then in terms of tracking error where large, rule‑based vehicles create predictable buying and selling patterns around index reconstitutions, through creations and redemptions. The exceptional growth of Tech stocks and large AI IPOs produce strong, non-linear gravitational and tidal effects that perturb nearby orbits of smaller companies: liquidity is redirected, volatility patterns shift, and formerly independent price movements become correlated with the dominant mass.
Over time this gravitational influence can trap Beta-capital in a well, reducing market breadth. We can see this in the diverging performance between Mangos, S&P50 and S&P500. If that gravity suddenly wanes or its orientation changes, trapped bodies can be flung into chaotic trajectories that amplify market dislocations and tail risk. This is an analogy that highlights fragility and underscores why some portfolio architects use hedges and structural adjustments to avoid being irrevocably drawn into a single, deep valuation well.
Index ‘Gravity’
Translating these cosmic mechanics to markets: a concentrated mass (mega‑cap, blockbuster IPO, or oversized ETF) creates steep “capital gradients” that redirect liquidity, induce correlated trading (resonances), and draw-in capital (capture) or, under stress, precipitate rapid outflows (ejection). The pulsar analogy emphasizes non‑linearity, path dependence, and the potential for abrupt systemic reconfiguration, a useful caution when designing portfolios and market structure. Market‑cap weighting plus ETF creation/redemption mechanics channel index inflows into the largest names, producing predictable demand at rebalance and inclusion dates. Lab and field studies such as ‘Regression Discontinuity and the Price Effects of Stock Market Indexing’ by Yen-Cheng Chang, Harrison Hong and Inessa Liskovich in 2015 documented an index inclusion premium and short‑run price pressure around additions, observing the Russell 1000 and 2000 indices.
Meanwhile tracking‑error constraints increase gravity. Core active managers (the vast majority of active money) are constrained to tight tracking‑error budgets; this can mechanically align active flows with index moves and reduce the cross‑sectional dispersion of bets, amplifying the gravitational pull of large index constituents. Industry analysis by the likes of Dr. Patrick Walker ‘Improved Tracking-Error Management for Active and Passive Investing’ (2024) point to the issues facing conventional tracking error management and notes;
“For some, the goal is to closely track these benchmarks - a task that can be challenging, especially when the benchmarks include assets that are difficult or expensive to trade. In this scenario, the primary objective is to minimize tracking error. Other managers aim to maintain an active tilt while not deviating too far from their benchmark, making the control of tracking error their key focus.”
Similarly, ‘The Use and Misuse of Tracking Error’ by Eric Sorensen Nicholas Alonso Daniel Belanger, for The Journal of Portfolio Management Performance Analysis (2023), warned that fixed TE mandates become problematic as benchmark concentration changes and;
“as the concentration of names in the S&P 500 increases, its diversification fades. When this happens, constant tracking error is the enemy of the skilled diversified manager.. high tracking dominates low tracking when index concentration is low, trending lower, and return dispersion is high. Low tracking dominates when the opposite index conditions exist.”
The evidence for and against market distortion is mixed:
Whilst the academic and industry hypotheses may be split; there are obvious observable mass effects occurring such as predictable liquidity spikes around rebalances and large IPOs (e.g. SpaceX created enormous demand and immediate price pressure on debut, with rapid entry to several indices expected) against narrowing index leadership where returns are increasingly driven by a handful of mega‑caps (e.g. Mangos), compressing both breadth of returns to the investor and elevating portfolio CAPE‑style metrics. On balance we gauge there enough evidence to support the notion of gravity wells and likely effects through Tracking Error.
Much is discussed then about whether large scale allocation back into an index through ETFs and index-tracking funds alone creates price distortion, by hindering short-term price discovery. There are counter views on this question, but our own is that trackers cannot logically add to price distortion in isolation because of the very tight tracking tolerances they maintain.
However, if the index weight is already distorted then adding more assets to that distortion only increases its effect, Beta. Large-scale trackers thus add to index gravity, by adding more assets into the largest constituents of an index (at close to index weight) which in turn de-scales the price effects of active investors taking different positions to the index. Further, the same index-weighted assets compete with active investors through reported performance and active manager persistency. Supply and demand remain a function of scale of buys to sells at a given price. When active investors and other participants are drawn-closer to the index (to maintain tracking error) then investors and portfolios correlate.
To that end we considered how tracking error affects the risk of Beta and thus the need for tail-hedges against any correction. For any chance of estimating these effects on tracking error, first we had to define what ‘gravity’ was as;
The term for index Gravity G then where C = index concentration (e.g., top‑10 weight), D = trading dominance/liquidity skew, I = IPO / new‑issue flow including lock-up expiry issuance; and (Beta) provides us scale parameters and since we are interested in how gravity is changing the riskiness of Beta. From which the Effective tracking deviation (the scalar proxy for how far a fund will be pulled towards the index by gravity) can be expressed as:
TE0 = fund’s baseline tracking error capacity (observed TE).
AS = active share where ∈ [0,1] active share (0 = full index clone).
γ = sensitivity of TE to index gravity (calibration parameter). This assumes that gravity exerts more pull-on funds that are less active (have lower AS) and that higher index concentration increases the tendency of active weights to revert toward benchmark. The structure follows standard practices where TE for many asset managers is a key portfolio constraint.
If index gravity does exist then it can be distorted, and that active funds with lower active share are affected the most by such gravity. The gravitational effect on passive funds will be observably low as the tracking errors are small (and managed on an intra-day basis) whereas core active (low active share) funds will likely display the highest effects; and high active share funds will still see effects on their off-index positions but to a lesser degree and far less likely to respond to tracking error. Moreover, if these distortions permeate and ripple through an entire index, then for allocators and investors how best to manage gravity risks?
Tail-hedging gravity: a use-case for absolute‑return funds
Where asset managers are being pulled ever closer to the large cap constituents of their benchmarked index, so as to manage tracking error, then the tail-risk arising from this grows. Here then is where we see the use-case for absolute‑return long/shorts funds, which can deliver low, stable beta while shorting the most expensive concentrations. This both helps short gravity effects arising from Beta (and tracking error) whilst also capturing factor premia on the long leg. For example, Fortem Absolute Return Fund explicitly implements a long factor‑optimised global equity sleeve and a ~70% short of the global parent index to target ‘Cash +2% with low, stable market beta’, which could be a useful compliment to your core or passive sleeves. What then for your Beta portfolio?
For allocators: consider dynamic TE allowances, concentration‑aware benchmarks (equal‑weight or systematic-weighted ETFs), and complement your passive and core exposure with absolute‑return, and perhaps also short-extension, sleeves.
For risk managers: monitor liquidity stress during rapid outflows, model risk in optimisation, and consider valuation and governance issues around mega‑IPOs. SpaceX’s IPO has highlighted both scale, earnings and governance concerns.
For Quants: Replicate and monitor the proposed function for Gravity and Effective Tracking Error and test against actual index and portfolio performance; use as a tool to help manage dynamic TE allowances.
Conclusion
Unquestionably, indexation and ETFs have improved access and liquidity for investors and markets, but the rise of AI stocks and Private Market intrusion through large IPOs create measurable gravitational effects on Beta, which can amplify concentration and valuation risks. The evidence is mixed, some distortions are documented, others are mitigated by arbitrage and information, but prudent portfolio design (dynamic TE, concentration‑aware vehicles, and absolute‑return hedges) can reduce your tail exposure.
Practising this kind of prudent behaviour will probably require ‘emotional fortitude’ from investors. Allocators who rely upon or manage-to tracking error constraints should now consider concentration, mass effects and index distortion, as their portfolios are drawn ever close to gravity wells. To boldly go…
Notes: A pulsar is a neutron star with mass comparable to the Sun compressed into a ~10–20 km radius, producing an intense gravitational field and steep spatial gradients in gravitational potential. That steep potential means the gravitational acceleration changes rapidly with distance, so objects at slightly different radii experience markedly different forces. This differential force is the origin of tidal effects that can stretch, compress, or torque nearby bodies and their orbits. Science | AAAS Springer
Tidal forces scale with the gradient of gravity: near a compact mass, the near side of an orbiting body feels a stronger pull than the far side, producing tidal stresses that can alter rotation, excite internal oscillations, or, for small bodies, lead to fragmentation. In orbital mechanics, strong tides can change orbital elements—semi‑major axis, eccentricity and inclination—by transferring energy and angular momentum between bodies and the central mass. Over time, these interactions can lock objects into new resonances or eject them into chaotic trajectories. Springer
A massive, compact intruder introduces resonant forcing: periodic gravitational perturbations at commensurate frequencies can pump eccentricity or inclination, producing secular (long‑term) changes in orbits. Binary pulsars and pulsar timing studies exploit these effects to test gravity; conversely, a pulsar passing through a planetary system would create long‑lasting orbital rearrangements and measurable ephemeris shifts. arXiv.org Cambridge University Press & Assessment
Close encounters can scatter small bodies, converting orbital energy into hyperbolic trajectories or capturing objects into tight orbits. The combination of strong local gravity, tidal dissipation, and resonant coupling makes outcomes highly sensitive to initial conditions—small differences in approach can yield capture, collision, or ejection. This sensitivity is why a pulsar’s passage is modelled as a source of systemic instability rather than a gentle perturbation. Science | AAAS Cambridge University Press & Assessment
Other Links/References:
eScholarship JSTOR University of East Anglia Portfolio Management Research BlackRock Fortem Capital ir.spacex.com CNBC