by WWM | Jun 24, 2020 | Diversification
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.
by WWM | Jun 17, 2020 | Diversification
Is your investment fund as diversified as you think it is?
Morningstar Canada considers this question in, “Is Your ETF Actually Diversified?”. And yes, the same question applies to mutual funds and other investment products.
The article does a good job of analyzing this issue. The focus being on how the method of index weighting can skew sector diversification. Worth a read.
But there are other lessons contained within, which are not considered by Morningstar.
Today I want to address how market weighting an index may distort sector diversification. And, more importantly, how to reduce this risk. We will cover other lessons in subsequent posts.
Index Weightings
Market indices (and related investment funds) may be created in different manners.
The two most common are market capitalization weighted and equal weighted. You may also occasionally see factor weighting and price weighting. But we will just look at the most common weightings.
Market weighted indices are created based on relative market capitalization of the holdings. If we use the S&P 500 as an example, behemoths like Microsoft, Apple, Amazon, and Google dominate based on their sheer size. While still large companies, relatively smaller stocks like Union Pacific, Danaher, and NextEra have minimal weightings.
Equally weighted indices do not factor in market capitalization. Microsoft is included in equal amount as Union Pacific. 500 companies in the index. Each carries 0.2% weight.
Index Investing May Not Provide The Diversification You Assume
The focus of the article is on how market weighted indices overweight certain industry sectors. This is true. Good to understand. I am just not sure it is that crucial for investors.
As the article points out, which overall market (e.g., country) the index covers will pinpoint the potentially over (or under) weighted sectors. What do I mean?
The iShares Core S&P 500 ETF (IVV) is a market weighted index proxy. Given the size of Microsoft, Apple, Google, Amazon, and Facebook, it is unsurprising to see that Technology is by far the largest market weighted S&P 500 sector at 26.7%. Trailing this is Health Care (14.4%), Communication (10.8%), Consumer Discretionary (10.7%), Financials (10.6%), and Industrials (8.0%).
If we compare that to Invesco’s S&P 500 Equal Weight ETF (RSP), Technology falls to second spot at 14.3% of the fund. Instead, in equal weighting, Industrials actually is the largest sector at 14.8%. A substantial redistribution versus the same companies under market cap weighting.
That is Morningstar’s point. By market weighting the S&P 500, you end up with an overweighting in Technology. This can negatively impact portfolio diversification. True.
Depending on how you calculate, your index may change the relative exposure to market sectors. However, changing relative sector weights by equal weighting, may or may not increase diversification. It depends, at least to me, on many other factors. Not simply weighting.
As well, should Union Pacific or NextEra carry the same weight in an index as Apple or Amazon? Does equal weighting better represent the large cap US stock market? I would argue that market weighting better reflects US equity reality. But your own mileage may vary.
Global Diversification
Part of the reason investors should diversify globally is to smooth out potential sector over-weightings in market indices. Different countries have different areas of dominance. By investing across markets, you can equal out your sector exposure and keep that diversification intact.
We saw in the S&P 500, that Technology dominates. But that is the US market.
In Canada, Financials (33%) rule the TSX Composite, with Basic Materials (14%), Oil and Gas (14%), and Industrials (11%) following. In Canada, Technology is only fifth, at 10%.
In Europe, consider the index fund, iShares Core MSCI Europe ETF (IEUR). Its top sectors are Healthcare (16%), Financials (15%), Consumer Staples (14%), and Industrials (14%). Technology is ranked seventh, at 7%.
In China, index fund iShares MSCI China ETF (MCHI) largest sector exposure is in Consumer Discretionary (27%), Communication (22%), and Financials (19%). Technology ranks seventh at 4%.
Canada offers significant Oil and Gas exposure versus relatively little in Europe or China. In turn, Europe is heavy in Healthcare, which is not a major sector in Canada nor China. And in China, Consumer Discretionary is a big sector. In Canada and Europe, much less so.
By investing in different geographical markets, your relative exposure to specific sectors changes. As well, you can allocate more to sectors or markets you think have upside. Whether that be overweighting a specific country index or in adding niche funds to your portfolio.
For example, if you are worried about not having enough Technology in your Canadian equity fund, you can add iShares S&P/TSX Capped Information Technology Index ETF (XIT) to complement your TSX Composite fund.
With so many ways to offset sector skewing, the concerns raised in the Morningstar article become less an issue.
Market Cap and Style Diversification
The same argument can be made for investing across different market capitalization indices (e.g., mega, large, mid, small, micro) or style (e.g., Value, Growth).
In the US equity market, mega cap companies (capitalization typically over USD 200 billion) dominate the S&P 500 index. The Apples, Amazons, Facebooks, Microsofts, Googles of the equity world.
The Russell 2000 tracks US small cap companies (capitalization typically USD 250 million to 2 billion). In this market segment, Healthcare (21.5%), Industrials (15.2%), and Financials (15.1%) exceed Technology (15.0%) for sector exposure. A marked difference from the S&P 500 breakdown.
With style, let us compare two mid-cap indices (capitalization typically USD 2 and 10 billion). We will use iShares S&P Mid-Cap 400 Value ETF (IJJ) and iShares S&P Mid-Cap 400 Growth ETF (IJK).
IJJ’s top five sector weights are Financials (23.1%), Industrials (13.7%), Consumer Discretionary (12.4%), Real Estate (11.7%), and Technology (10.0%).
IJK’s top five sector weights are Technology (22.0%), Industrials (17.9%), Consumer Discretionary (14.9%), Healthcare (14.5%), Real Estate (9.1%).
First, we see variation in sector weightings between US market equities of small, mid, or mega capitalization. Second, even within the US mid-cap market, there are different sector weightings based on whether the companies are Value or Growth stocks. Both findings make sense and are expected. And a reason to diversify into asset subclasses.
It is useful to understand the differences between market and equal weighted indices. And that market weighting can skew sector allocations. That said, there are many ways to adjust sector weights on your own. Then create the allocation you desire.
by WWM | Apr 10, 2019 | Diversification
Before we move on to the next phase on investing, I want to highlight asset correlations and expand slightly from comments I made in a fixed income post. Not the easiest topic to explain nor understand. But critical in understanding why diversification plays such an important role in building a proper investment portfolio .
Diversification and Asset Correlations
We covered Diversification and Asset Correlations previously.
Correlation is a statistical measure of how one asset moves in relation to a second asset.
Many variables impact how two assets react to each other. In the linked article, I used two Starbucks as an example. At a very close level, with only a few variables, there are still some differences in operations and performance. The greater the number of variables, the greater the differences in returns of each Starbucks location.
It is an identical relationship between bankable assets, such as equities. Two Western Canadian operating oil companies’s shares will be impacted by oil prices, taxes, the economy, and so on. But differ based on their management, the ability to find productive plays, etc. This will differ too versus an oil company operating in Iraq or Texas. Because there are more variables and the impact on a Calgary versus Iraqi oil company will be different to some extent.
Correlation Coefficient
The correlation coefficient measures how closely two assets move in lockstep.
Perfect movement together is 1.0. Perfect movement in opposite directions is -1.0. No correlation between the two assets would be 0.0. Assets within a specific asset class tend to be relatively highly correlated to each other.
This figure is important when calculating portfolio risk. There is no impact on return.
If you review, Asset Correlations in Action, you can see the mechanics of how adding any asset to your portfolio that is not perfectly, positively correlated, will reduce overall portfolio risk. The level of risk reduction will be based on the correlation between the assets, as well as the quantity added.
If you have a $100,000 portfolio and add an asset with with a correlation coefficient of -0.60, you will get some nice risk impact. But if you only add $1000 of that asset, the impact is negligible. Whereas, adding $75,000 in an asset with 0.50 will actually be preferable due to the amount.
Also, while you want to look for lower correlated assets to add to your portfolio, do not forget about return. Many assets that have low correlations to stocks, for example, may also offer lower expected returns. The correlation coefficient does not reduce returns, as it does with risk. But you may suffer lower portfolio returns by adding lower return assets just to meet your goal of adding non-correlated assets to the mix.
But Do Not Exclude Lower Return Assets Outright
As I covered in Asset Allocation: Fixed Income (Part 1), that does not mean lower return fixed income should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.
Fixed income (currently) has a negative correlation to many equity subclasses. That means the assets move in relatively opposite directions. If equities fall in price, then bonds, even at lower rates, will do well. So, yes, bonds may have lower long-term expected returns than equities. But when equities experience bear markets, bonds provide a safe haven.
I say “currently”, as correlations are not stagnant. They can shift up or down (or reverse themselves) over time based on changing economic factors. Periodically review asset correlations within your portfolio to ensure they are still optimal.
For example, many years ago, emerging market equities offered excellent diversification to domestic stocks for Canadians or Americans. That is because, for many reasons, domestic companies tended to operate primarily in their own countries or regions. What was happening in Japan, Argentina, or Germany, had relatively little impact on a business serving the Mid-West US markets. But as international trade grew, the correlations also rose. Still diversification benefits to emerging markets, but less than in the past.
Going back to our Starbucks example. Starbucks began life in 1971. A single store in Seattle. In 1987, Starbucks finally expanded out of Seattle, to Vancouver and Chicago. What Australians or Swiss drank was of no concern. It was not until 1996 that Starbucks expanded outside the US, with a location in Tokyo. 25 years of revenues solely from North America. Yet by 2018, Starbucks had over 27,000 locations in 76 countries or territories. A good example of globalization and shrinking of borders business-wise. As the world changes, so too may inter-asset correlations.
Correlation of Fixed Income
Consider a few current inter-asset correlations, using data from Portfolio Visualizer as at March 15, 2019.
The current 10 year correlation between 20 Year U.S. Treasury Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.47; U.S. Mid Cap Stocks −0.46; U.S. Small Cap Stocks −0.45; International (excluding U.S) Stocks -0.43; Emerging Market Stocks -0.38.
As I wrote above, combining two assets with negative correlations is very beneficial in reducing portfolio risk. And any correlation below 1.0 (perfect positive correlation) improves overall portfolio efficiency. But the lower, all the way to -1.0 (perfect negative correlation), the better for diversification of portfolio risk.
Fixed income offers excellent diversification potential in an equity laden portfolio.
When we look at alternative asset classes, fixed income can also enhance diversification. Consider the latest 10 year correlation between 20 Year U.S. Treasury Bonds and: U.S. Real Estate −0.22; Commodities -0.22; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.
Do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between the 20 Year U.S. Treasury Bonds and U.S. Municipal Bonds is only 0.37. So there is still value in diversifying within the asset class.
Of course, you also need to factor in asset risk (standard deviation) and expected annual return in your portfolio calculations. Adding a high risk, low return asset to your portfolio simply because it has a low correlation may not be wise.
Note as well, going to my point on globalization impacting asset correlations. Today, emerging market equities have a very positive correlation of 0.83 to US domestic equities. 40 years ago that correlation was much lower, with much higher diversification impact. Be sure to monitor for changes in correlations over time.
Okay, enough on asset correlations. But important to understand when we begin building portfolios. Otherwise, the question is always, “Why would I ever want 3% bonds in my portfolio if stocks expect 8% annually?”
by WWM | Feb 27, 2019 | Asset Classes, Risk, Target Asset Allocation
The core asset classes have general risk-return characteristics.
The greater an investment’s risk, the greater the demanded return by investors.
Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.
But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.
We will look at a few examples today.
Cash and Cash Equivalents
In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.
But not all cash equivalents fit this profile.
For a U.S. resident investing in short-term U.S. Government Treasury bills, those characteristics hold true.
High Risk Countries
But the Venezuelan bolívar is also cash. For a U.S. resident investing in bolívar during 2018, the hyperinflation in Venezuela made this currency worthless.
Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentines, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentines awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.
What did that mean?
If you bought a USD 600 television imported from America, it cost 600 pesos in December 2001. Less than a year later that same purchase cost 2400 pesos.
Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.
Even Low Risk Countries
If you think it is simply countries such as Venezuela and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.
For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.
And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.
Two highly regarded currencies. Yet not a low risk, low return investment, was it?
When investing internationally, whether to hedge your foreign currency is always a concern. There are pros and cons to hedging (or not). What is preferable for one investor will differ from the next. And there are multiple variables that require consideration before deciding if hedging is right for your portfolio.
Fixed Income
Fixed income securities are generally considered to be higher risk and higher return than cash equivalents. But lower risk and return to common shares.
Yet again, individual fixed income securities can differ from this generality.
Credit Rating
Fitch Ratings classifies the “safest” bonds at AAA. Lowest investment grade bonds are BBB. Bonds in default are rated D.
As you would expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.
Conversely, the greater the risk that the bond issuer will be unable to pay the interest and principal, the more incentive is required to attract investors. That incentive could involve “sweeteners”, though often it is simply offering higher yields.
For example, consider four bonds, maturing in 18 years, with no sweeteners or provisions. Data as at February 26, 2019.
Government of Canada 5.00% 01-Jun-2037 are rated as AAA. The yield to maturity (YTM) is 2.074%.
Hydra One Inc. 4.89% 13-Mar-2037 are rated as A (High). The YTM is 3.628.
Bell Canada 6.17% 26-Feb-2037 are rated as BBB (High). The YTM is 4.258%.
Shaw Communications Inc. 6.75% 09-Nov-2039 are rated as BBB (Low). The YTM is 4.834.
You can readily see, as the risk of default increases, the yield to maturity required by investors also rises.
Equities
Of the three core asset classes, common shares traditionally have the highest risk and return.
But this may not always be true.
Other Asset Classes May Outperform
We looked at some fixed income yields above. Assuming a hold until maturity, yields between 2% and 4.8%. Relatively safe, but also relatively low return.
What if we compare this to Canadian equities?
On February 27, 2018, the TSX Composite closed at 15,671.15. On February 25, 2019, it closed at 16,057.03. A one year return of only 2.68%. Lower return than many bonds, yet much higher risk.
Of course, one year is a very short time frame. Too short to properly assess higher risk assets. Over the 10 years ended February 25, 2019, the TSX Composite earned investors more commensurate average annual returns of 7.31%.
Never focus on short term performance for higher risk investments.
Differences Within the Class
Of the three core asset classes, there are the most subclasses within common shares.
Mega cap shares will normally have less risk and return than micro or nano cap companies.
Value stocks may be less volatile than growth stocks.
Dividend producing companies may be lower risk than capital appreciation shares.
Foreign companies may have more risk than domestic.
Defensive stocks may be less risky than cyclicals.
Mining companies may be riskier than utilities.
Or, depending on economic conditions, the opposite may be true.
The individual common shares you select will have a different risk-return profile than common shares as a whole.
That is why investors often diversify through multiple subclasses, to spread the risk. Or purchase exchange traded or mutual funds, that usually contain a substantial number of individual investments to diversify risk somewhat.
That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But the ability to time the market is not easy and the transaction costs can be steep. Many investors get the timing wrong and end up costing themselves return.
Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.
There are many other examples possible, but this gives you an idea as to what I am saying.
by WWM | Aug 8, 2018 | Active vs Passive Management
A goal of passive investing is to match the market return as closely as possible.
However, it is not a given that a passively structured investment will match its own market. In fact, there may be material variations between different investments and the benchmark index performance.
Index funds (both mutual and exchange traded) are typical passive investments. Here is why they do not normally exactly match their benchmark returns.
Operating Costs
Index funds incur operating costs that are not present in the benchmark index.
While there may be little to no management fees charged, there will still be expenses for: commissions on buying and selling securities; accounting for fund assets; shareholder communications; regulatory filings; staff salaries; etc.
These costs cannot be avoided. Any fund that you invest in will be at an immediate disadvantage in trying to match the market return.
The more efficient the fund, the lower the relative costs. As well, there is often economies of scale for larger funds. Operating costs cannot be avoided entirely. But be sure to compare funds before investing. There will be differences.
Transaction Timing
Even if we could avoid all fund costs, it still may still be difficult to exactly match the benchmark index performance.
Securities need to be bought and sold on the open market to properly track an index.
For example, per a June 19, 2018 S&P Dow Jones Indices news release, “Walgreens Boots Alliance Inc. (NASD:WBA) will replace General Electric Co. (NYSE:GE) in the Dow Jones Industrial Average (DJIA) effective prior to the open of trading on Tuesday, June 26.”
If you are an index fund that mirrors the Dow 30, you may need to sell your holdings of General Electric and replace them with Walgreens. There is no guarantee that the price you receive for General Electric, or pay for Walgreens, will be the same as calculated by the benchmark as at the close of business on June 25. This likely will create a variance in fund performance versus the benchmark.
Compounding this problem is that there are many funds that track this index.
The more funds that reflect a specific index means more competition for shares of securities added to an index and more sellers of securities that have been removed from an index. If there is suddenly either increased supply or demand, it can cause significant price fluctuations.
When a fund can invest and divest securities may have an impact on its performance versus the benchmark. Think of the price impact on General Electric as all the tracker funds holding this stock sell their shares. And what will be the short-term price impact on Walgreens as these same funds buy all available shares of this stock?
Obviously, the smaller and/or less liquid an index, the greater the fluctuations likely between purchase and sale prices on equities entering or leaving the index.
Fund Construction
Variances between performance in the benchmark and index funds may relate to how the fund is structured.
Not all index funds are created equally.
Index funds may be created using full, partial, or synthetic replication.
Full Replication
Full replication involves holding every security in the index in its appropriate weighting.
With complete replication, an index fund’s gross returns should be close to to the index itself.
As the relative weightings of securities can fluctuate based on security price and capitalization, to stay fully replicated may require frequent trading. How quickly the fund can adjust its portfolio will impact matching gross index returns.
Also, increased trading will increase fund operating costs. This reduces fund performance versus the actual index which does not incur any expenses. The increased fund turnover can also create taxable capital gains for investors, once again impairing net returns.
Partial Replication
Partial replication does not hold all an index’s securities. Instead, it only maintains a representative sample of the securities within the index.
The better the sampling techniques, the closer the gross returns should be to the index. But when not fully replicating an index, there is a greater risk that actual returns will deviate from the actual benchmark or a portfolio using full replication.
This is known as the index fund’s tracking error.
Tracking error is not a one way street. It can also result in a fund achieving higher gross returns than the benchmark.
An advantage of partial replication is that by owning fewer securities, there is less trading (and transaction costs, administration expenses, triggering of capital gains, etc.) than under full replication.
Whether partial replication is preferable to full depends on the quality of the sampling technique.
Synthetic Replication
Whereas full or partial replication requires the fund to own all or some of the benchmark index holdings, synthetic replication does not.
Synthetic replication uses financial instruments to replicate the index performance. These may include the use of futures, swaps, and other derivatives.
An advantage of synthetic replication is that it is usually easier and more cost-effective to re-create and manage the benchmark using financial instruments rather than investing in individual securities.
There still may be some tracking error in performance depending on the specific benchmark index and the availability of financial instruments. For established markets though, tracking error should be small.
A potential problem arises for less established markets where finding an exact match of financial instruments is not simple. In these instances, the fund may need to rely on a less than perfect fit in trying to replicate the market. This will increase tracking errors.
Also, it may require the fund to enter into swaps with other entities to replicate the benchmark index. This creates counterparty risk (risk that one side of the transaction will not fulfill its obligations) and can impact fund performance should the counterparty default.
While trading and administrative costs are reduced with no actual securities being owned, there are still costs associated with a synthetic strategy. These include fees associated with the financial instruments used. In established markets, there are many options for replication, so the costs tend to be reasonable. But in less established markets, it may not be as easy to find replication solutions and the costs will rise.
It is not imperative that you memorize the mechanics of fund construction. It is simply a reality of index funds.
But always keep in mind that a passive investment may not exactly match the return of the market it represents. And the reasons for that lie (mainly) in the above points.