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.
