A Real Fund Diversification Problem

In “Diversification and Index Weighting”, we looked at how market capitalization weighted versus equal weighted indices can impact industry sector allocations in an index or investment fund. As well, simple measures to ensure your fund is diversified across sectors.

This was based on Morningstar Canada’s, “Is Your ETF Actually Diversified?”

A more realistic diversification problem with market weighted indices is the impact that relatively few holdings can have on the overall index performance. This is an area where I see investors get confused all the time.

Too Much Exposure in a Fund

You buy into a fund with 300 holdings. Way more than enough diversification. That is what we want, right? Yes, but …

The S&P 500 contains (roughly) 500 different companies. It deviates a bit in reality. 500 companies is a lot of diversification. In an equal weighted index, yes. Each holding will make up 0.2% of the index. The top 10 holdings will be 2%. The top (and bottom) 250 will be 50%. Each holding contributes equally to diversification, return, and risk.

But the impact differs greatly under market weighting.

Okay. But 500 stocks is a whole lot and that spreads out investment risk nicely.

But does it? At least to the extent it appears on the surface.

What if I told you that the top 10 holdings in the S&P 500 make up 26.6% of the total assets under instrument (AUI)? Or that the top 20 and top 30 holdings represent 35.9% and 43.2%? Out of 500 stocks in the portfolio, only 30 make up almost half the AUI.

Is that as diversified as you thought a 500 stock portfolio would be?

Looking at it another way, Microsoft (5.67%), Apple (5.65%), and Amazon (4.19%) are the largest holdings in the S&P 500. These three companies make up 15.51% of the index.

In comparison, the smallest 150 companies of the 500, combine for 4.49%. 150 companies equals a single Microsoft, Apple, or Amazon in clout.

Going farther, the smallest 250 companies, fully half the index, only account for 10.52% of the total. And the smallest 400 companies only achieve 29.14% of the index.

Versus the top 12 largest companies that weigh in at 29.60%.

Yes, an S&P 500 fund may provide you with 500 different companies. But how many companies in that index actually impact annual performance? Probably fewer than 50.

50 different companies is still pretty good for diversification (at least if we do not factor in industry, geography, etc., that impact correlations). But if you think you are getting the diversification benefits of 500 companies, this is not true due to the use of market weightings.

Not Just an Index Fund Issue

The same problem often is true with most actively managed mutual or exchange traded funds.

In Canada, consider some of the largest mutual funds.

The Pimco Monthly Income Fund is primarily a bond fund. It has 2224 holdings and CAD 22.3 billion in AUI. Lots of holdings. Yet its top 5 account for 34.1% in AUI.

The RBC Canadian Dividend Fund has 83 holdings and CAD 16.4 billion in AUI. Yet, the top 5 holdings account for 30.3% of all assets. The top 10, 46.5% of AUI.

The Fidelity Canadian Growth Company mutual fund has 92 holdings and CAD 6.9 billion in AUI. Its top 5 holdings are 27.3% of AUI. Its top 10 holdings make up 46.0% of all assets.

Again, you may think you have a ton of diversification when you invest in funds with a relatively large number of holdings. But it is important to look beneath the surface.

Always review the top 10, 20, and 30 holdings as a percentage of overall AUI. That will help inform you as to how many holdings truly impact that fund’s performance and diversification.