Best way to mitigate the top heaviness of Total Stock Market Funds

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bikechuck
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Best way to mitigate the top heaviness of Total Stock Market Funds

Post by bikechuck »

As I age and simplify my portfolio I love the idea of reducing my equity holdings to a single total stock market index fund. However I have concerns about the fact that in most of these funds 10 large companies compromise 20% of the fund value which reduces the diversification objective.

Diversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.

Thanks in advance for your thoughts.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by dwickenh »

It is not the same 10 companies over time. I would like to be more exposed to more successful companies as long as it represents their size in comparison to the rest of the market.
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KlangFool
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KlangFool »

OP,


A tilt to SCV and Active Management. I do both.

A) 10% of my portfolio is in the SCV pair with another 10% in the Intermediate-Term Treasury as part of my mini-Larry Portfolio.


B) 40% of my portfolio is in the actively managed Wellington Fund (65/35).


C) Only 40% of my portfolio is in the 3-funds.


KlangFool

P.S.: My overall AA is 60/40.
Last edited by KlangFool on Tue Oct 20, 2020 11:54 am, edited 1 time in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by asif408 »

If I was retired or nearing retirement and had enough to retire comfortably, I would hold my safe assets in bonds/CD/TIPS, and for the stock portion, I'd split 1/3 US, 1/3 international developed, & 1/3 emerging markets. To me that would seem to be the safest way to mitigate long term poor performance in any one asset and gives you broad diversification. I'm not sure adding small cap stocks in one country is going to help you as much from a diversification perspective, though if international is not a consideration, I guess adding small caps is better than nothing.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by nisiprius »

I don't believe there's any need to mitigate the alleged "top heaviness" of Total Stock Market Funds. What's your reason for thinking you need to? The stock market is always that way, and it is my belief that people are raising phony concerns and taking advantage of people who haven't paid attention to the natural distribution of stock market capitalization.

Of course there are argument either way, but there has never been a time in the history of the stock market when the largest stocks haven't a "disproportionate" share of the money. You can see this even in something as simple as the S&P 500. There are very roughly 3,500 stocks in the market, yet the S&P 500, with only 1/7th of the stocks, have 80% of the money invested in them.

The financial economics theory behind indexing, which of course involves unrealistic assumptions etc., is that you are trying to mirror the market as it is, not as you think it should be.

50% of Shakespeare's words come from the list of the 100 most frequent English words. So are 50% of mine. Do you think my writing would be better if I avoided using them? Should I try to equal-weight my words and use "usufruct" as often as I use "the?"

Before asking what is the best way, be sure that you think it is necessary. Why do you think it is necessary? Because someone a) pointed out something you didn't know about the distribution of cap-weight in the stock market and b) pointed it out in a way that implied there is something bad about it?
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Post by Taylor Larimore »

bikechuck wrote: Tue Oct 20, 2020 10:38 am As I age and simplify my portfolio I love the idea of reducing my equity holdings to a single total stock market index fund. However I have concerns about the fact that in most of these funds 10 large companies compromise 20% of the fund value which reduces the diversification objective.

You should be pleased that you hold the market weight in the 10 largest and most successful companies in the United States.

Diversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.

Overweighting market categories does not increase diversification, it increases concentration and is likely to reduce returns.

Thanks in advance for your thoughts.
Best wishes.
Taylor
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by UpperNwGuy »

I see no need to mitigate the top heaviness of total stock market index funds. In every era there have been a few large companies clustered at the top. Right now they happen to be tech companies. I own them at market weight. Not a penny more nor a penny less.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Normchad »

I’ll just point out, if you decide to tilt, or beef up mid-caps or whatever, you are intentionally concentrating in those area to an extent. Concentration like that lowers your diversification.....

There is nothing wrong with doing that. A lot of very well reasoned people on these boards do those things. Just be sure you understand what you’re doing, why you’re doing it, and what you think the potential gain to you is from doing it.

Some may choose to do it because they think Apple, Amazon, are priced to perfection and have nowhere to go but down. If that is your reasoning, then this starts to sound like market timing.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Steadfast »

What I love about holding a single, total-market fund (Total World in our case) is that if one or more of the big heavyweights at the top of the index falls - or even if all of them did, entire industries or dominant sectors - the market stands ready to carry out the ruthless calculus about their new value and reshuffle the deck, replacing the faded giants with the rising stars. The markets do it every day. It is exactly what they are there to do. The best part is I don't have to do anything to benefit from this amazing machinery other than pay 0.08% and stay the course.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Normchad »

Steadfast wrote: Tue Oct 20, 2020 11:44 am What I love about holding a single, total-market fund (Total World in our case) is that if one or more of the big heavyweights at the top of the index falls - or even if all of them did, entire industries or dominant sectors - the market stands ready to carry out the ruthless calculus about their new value and reshuffle the deck, replacing the faded giants with the rising stars. The markets do it every day. It is exactly what they are there to do. The best part is I don't have to do anything to benefit from this amazing machinery other than pay 0.08% and stay the course.
Great post. All the awesome historical index performances happened even though this type of corporate downfall was going on. Westinghouse and GE fell hard for example, but the machine just kept chugging.

I too like to keep it simple.....
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by statman »

Several responses have noted that the are always a relatively few heavily weighted stocks in cap-weighted indices. But they are not always as sector-concentrated as now, with the FAANG stocks dominant. These stocks display very high valuations by traditional metrics, and are the target of impending legal and regulatory action both in the US and in Europe. I share the OP's concern about the heavy weight of these stocks in e.g. VTI. One possible alternative for some of an equity allocation is VIG, which screens by 10 yrs of increasing dividends. The result is NOT a high-dividend fund, but the FAANG stocks are screened out.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KlangFool »

statman wrote: Tue Oct 20, 2020 11:53 am Several responses have noted that the are always a relatively few heavily weighted stocks in cap-weighted indices. But they are not always as sector-concentrated as now, with the FAANG stocks dominant. These stocks display very high valuations by traditional metrics, and are the target of impending legal and regulatory action both in the US and in Europe. I share the OP's concern about the heavy weight of these stocks in e.g. VTI. One possible alternative for some of an equity allocation is VIG, which screens by 10 yrs of increasing dividends. The result is NOT a high-dividend fund, but the FAANG stocks are screened out.

statman,

I disagreed. We had seen the same story before: Telecom Bust and DotCom Bust.


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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Normchad wrote: Tue Oct 20, 2020 11:44 am I’ll just point out, if you decide to tilt, or beef up mid-caps or whatever, you are intentionally concentrating in those area to an extent. Concentration like that lowers your diversification.....
This is factually incorrect: holding mid-caps (or small caps) above their market cap weight definitively increases portfolio diversification.

It has other effects too so it may or may not be appropriate based on the investor's goals and risk profile, but improved diversification is definitely one benefit of this strategy.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Kenkat »

Steadfast wrote: Tue Oct 20, 2020 11:44 am What I love about holding a single, total-market fund (Total World in our case) is that if one or more of the big heavyweights at the top of the index falls - or even if all of them did, entire industries or dominant sectors - the market stands ready to carry out the ruthless calculus about their new value and reshuffle the deck, replacing the faded giants with the rising stars. The markets do it every day. It is exactly what they are there to do. The best part is I don't have to do anything to benefit from this amazing machinery other than pay 0.08% and stay the course.
Just realize that the rising star will likely come from the small cap market segment. Yes, you will own a slice as part of the total market fund but you’d own a bigger slice with a slant towards smaller stocks. Whether this matters or not in the long run has been discussed at length and there is no right answer that can be determined in advance, so there are many valid strategies out there.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by zeke1975 »

You could always look at one of the broad market fundamental index funds, like Schwab's FNDB. You'll still hold all those great companies, just not at their cap weights.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Normchad »

vineviz wrote: Tue Oct 20, 2020 12:02 pm
Normchad wrote: Tue Oct 20, 2020 11:44 am I’ll just point out, if you decide to tilt, or beef up mid-caps or whatever, you are intentionally concentrating in those area to an extent. Concentration like that lowers your diversification.....
This is factually incorrect: holding mid-caps (or small caps) above their market cap weight definitively increases portfolio diversification.

It has other effects too so it may or may not be appropriate based on the investor's goals and risk profile, but improved diversification is definitely one benefit of this strategy.
Vineviz, you post in here a lot, and I appreciate it. Based on my previous thinking on your posts, I will assume that you are correct in this instance and that I was mistaken. I will need to read up on this more and see where I went astray.

Thank you for all your great posts.....
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by fwellimort »

I've thought it was known in the stock market that most of the growth of the US stock market is fueled by only a handful of companies (relative to the number of companies in the market). One of the reasons individual investors struggle to beat the market is cause most stocks (like 80+% of them) are just net negatives. It's really the top few stocks in any decade that really drive the US stock market growth.

And there were even researches done in the past of why individual investors under perform the market. And one of the main ones (outside fees and taxes) is that individual investors sell winners to buy losers.
The concept of 'sell when it's high' while it sounds nice basically implies, 'sell the good companies and keep buying companies that are not as good'.
If you think about it, it sounds weird.
Company A is a great company. It is doing well, making a lot of money, and has a good future.
Company B is struggling and the future is quite murky.
Since Company A is doing well and looks like it will continue doing well in the near future, I will sell Company A for Company B to 'diversify' (di-worse-ify?).
If you keep doing this, long term, you end up selling all the good winners and have the poor losers. Not a good strategy long term.

At the same time, no one knows the future and there are time periods in which good companies are just overvalued. But just do keep that in mind.
Only a minority of stocks result in all the gains of the stock market. Most companies are just dead weight. And that historically, one of the main reasons investors under-performed the market was they kept selling the winners for the losers cause 1. price was too high 2. diversify.

One of the main reasons indexing works so well is cause it makes you hold onto the winners and when the winners no longer become winners, those companies slowly get filtered out and replaced with the new winners. Something the average investor has trouble doing him/herself.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by jakehefty17 »

You want to tilt your portfolio but hold fewer funds.

I decided to do this with my Roth IRA and HSA accounts (aggressive tilt small/mid)... 401k and taxable is in total market indexes. Kind of a science experiment over the long term, but it does provide a slight tilt in overall holdings. Staying the course is the important part.

Personally, I use an S&P 500 index fund plus an extended market index fund. Overweight the extended market fund to your liking.

That's the simplest way I know of... if it's worth your time.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by garlandwhizzer »

vineviz wrote:

Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level.
1+

This is a simple and effective strategy IMO if you desire increase smaller cap stocks to a higher allocation than in TSM. You may adjust the proportions of these two to your own taste. There is no certainty whether large or small cap stocks will outperform going forward. Each tends to go through alternating multi-year cycles of outperformance and underperformance relative to the other. In recent years large cap especially LCG has been the market leader but that won't last forever. It is best to keep in mind that small cap stocks are expected to be more volatile and perhaps carry greater risk relative to large well established companies. Also keep in mind that typically small cap stocks are more closely tied to their own respective domestic economy whereas large cap stocks have much greater exposure to global markets where LC companies world wide compete. Good luck.

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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by BroIceCream »

There was an excellent youtube broadcast from the September AAII conference... "Which Is the Best 1-, 2-, 3- and 4-Fund Strategy?" https://youtu.be/c7MyB_Of3Lg
It talked about what [positive] results can occur when such tilting is added. It also had data with a Bogle-like "Tell-tale" chart comparing a four-fund with a one-fund (SP500/TSM). I found the data presented very thought-provoking.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Uncorrelated »

vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
How do you define diversification?

According to research from AQR based on Fama/French 3 model, the SmB factor does not have positive alpha. It is my belief that if one "improves diversification", that should show up as alpha in a CAPM model, but there is none. How do you explain that?
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by bikechuck »

vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
Thanks Vineviz, my wife and I are in our mid to later 60s and approx 3 years into retirement. For the equity portion of our portfolios ... I have had a small cap fund totaling 10% of my U.S. equities for some time in addition to my total market fund and my wife recently consolidated from many equity funds down to one total U.S. equity fund. I appreciate your input along with comments from others.

I especially want to thank Taylor Larimore as I have learned so much from his thoughtful posts and publications re the benefits of a simple portfolio. We will own no more than two U.S. Equity funds unless we pull back to one. If we keep two it will be a small cap fund and we will keep it at 10% of our U.S. equities.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Halicar »

Wouldn't the simplest solution be to hold short positions on those ten companies?
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by sleepysurf »

vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
Another option is to add a slice of Vanguards Extended Market Index (VEXAX) which comprises the Total Market minus the S&P 500, thus a Mid and Small Cap "size tilt." However, being market-cap weighted, it doesn't offer any "value tilt" if OP is so inclined.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by sycamore »

statman wrote: Tue Oct 20, 2020 11:53 am Several responses have noted that the are always a relatively few heavily weighted stocks in cap-weighted indices. But they are not always as sector-concentrated as now, with the FAANG stocks dominant. These stocks display very high valuations by traditional metrics, and are the target of impending legal and regulatory action both in the US and in Europe. I share the OP's concern about the heavy weight of these stocks in e.g. VTI. One possible alternative for some of an equity allocation is VIG, which screens by 10 yrs of increasing dividends. The result is NOT a high-dividend fund, but the FAANG stocks are screened out.
I agree with the idea of considering other indexes/funds for a portion of your equities to reduce exposure to certain sectors.

VIG (Vanguard Dividend Appreciation) avoids the FAANG stocks (Facebook, Apple, Amazon, Netflix - or is it nVidia now, Google). While I like and own VIG, note that it has significant overlap with S&P 500's and Total Stock Market's top 10 holdings including Microsoft, P&G, Johnson & Johnson, and Visa. Home Depot and UnitedHealth are #6 & 7 in VIG and #14 and 15 in VTI.

Top 10 of VIG are 35% of assets whereas VTI top 10 are 24% of assets.

So VIG may help avoid the tech stocks (12% in Tech vs 26% for VTI) but it's still pretty top heavy overall.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by bikechuck »

sleepysurf wrote: Tue Oct 20, 2020 1:57 pm
vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
Another option is to add a slice of Vanguards Extended Market Index (VEXAX) which comprises the Total Market minus the S&P 500, thus a Mid and Small Cap "size tilt." However, being market-cap weighted, it doesn't offer any "value tilt" if OP is so inclined.
Thanks, if you add VEXAX to an S&P 500 fund would you essentially have the equivalent of a U.S. Total Market Fund?

I suppose that if you added it to a total market fund you would thin out the disproportionate impact of the largest ten companies and you would do so with both small and mid cap companies so this is something to consider that I would not have thought of on my own so I appreciate your post.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by nisiprius »

statman wrote:...Several responses have noted that the are always a relatively few heavily weighted stocks in cap-weighted indices. But they are not always as sector-concentrated as now, with the FAANG stocks dominant...
Things vary all the time. In 1980, seven of the top ten were Exxon, Standard Oil of Indiana, Schlumberger, Shell Oil, Mobil, Standard Oil of California, and Atlantic Richfield. It was more concentrated in energy companies then than it is in tech now. If CNBC had existed someone probably would have been saying "it's not Wall Street any more, it's SSSSAME Street."

The idea behind indexing is to mirror the stock market as it is. When the market is putting more of its money in tech, you are doing the same thing. When it is putting more of its money in oil companies, you are doing the same thing. You are doing whatever the market does.

There's no magic here but doing this has a number of good points that need to be weighed along with the bad. The plan of mirroring the market may mean you have a lot of money in a few stocks, but it also means that you were invested in these companies all the way up as they made it into the top ten.

And the burden of proof is on those who suggest there is something so wrong with that, that sticking to it is a bad plan.
Last edited by nisiprius on Tue Oct 20, 2020 9:10 pm, edited 1 time in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Uncorrelated wrote: Tue Oct 20, 2020 1:36 pm According to research from AQR based on Fama/French 3 model, the SmB factor does not have positive alpha. It is my belief that if one "improves diversification", that should show up as alpha in a CAPM model, but there is none. How do you explain that?
Alpha is not an effective way to measuring diversification, for two reasons:

1) A factor regression of a rebalanced portfolio simply produces the arithmetic mean factor exposures of the constituent asset returns, so fails to capture any diversification benefits (which are measured using geometric and harmonic means, not arithmetic means).

2) The goal of diversification is risk control, not return enhancement. A portfolio which is 50% stocks and 50% intermediate Treasuries is more diversified than a portfolio of 100% stocks, but obviously the diversified portfolio has lower expected returns than the concentrated portfolio.

The easiest way to observe a gain in diversification is to compare the volatility (or variance) of the portfolio to the weighted average volatility of each asset. Here's an example:

Image

Compare the weighted average return and weighted average volatility small caps (line 1) and large caps (line 3) to the CAGR of the combined portfolio (line 3).

The weighted average return of small and large caps is 10.47% but the combined portfolio had a CAGR of 10.62%, for a gain of 0.16%.

The weighted average volatility of small and large caps is 17.32% but the combined portfolio had a volatility of 16.65%, for a reduction of 0.67%

The benefit on return is incidental (an artifact of the fact that the two funds had different returns over this time period). If the two funds had the same returns over the observed period then diversification would have produced no benefit in terms of CAGR, but the reduction in volatility would still remain.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by sleepysurf »

bikechuck wrote: Tue Oct 20, 2020 2:29 pm Thanks, if you add VEXAX to an S&P 500 fund would you essentially have the equivalent of a U.S. Total Market Fund?

I suppose that if you added it to a total market fund you would thin out the disproportionate impact of the largest ten companies and you would do so with both small and mid cap companies so this is something to consider that I would not have thought of on my own so I appreciate your post.
Exactly! An ~80:20 ratio of S&P 500 : Extended Market Index replicates the Total Stock Market Index. Per our wiki, "Extended market index funds contain small-cap and mid-cap companies, but not large-cap companies listed in the S&P 500 Index. These funds are designed for investors already using S&P index funds" (see... https://www.bogleheads.org/wiki/Extende ... index_fund).

In my portfolio, I'm using VEXAX to counter-balance my S&P 500 and other (legacy) Large Cap funds and individual stocks. I'm actually using a ~70:30 ratio, thus adding a slight Mid and Small Cap tilt.

However, as MotoTrojan pointed out in a previous thread (viewtopic.php?p=5145887#p5145887), combining the Total Stock Market with Small Cap Value historically offers a greater risk-adjusted return.
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Small Value Stocks Reduced Total Market Returns

Post by Taylor Larimore »

However, as MotoTrojan pointed out in a previous thread (viewtopic.php?p=5145887#p5145887), combining the Total Stock Market with Small Cap Value historically offers a greater risk-adjusted return.
Bogleheads:

Using past performance to predict future performance is so dangerous that the government requires mutual fund companies to tell us it is dangerous.

For proof, look at Small-Cap Value investors who relied on past performance 10-years ago. These investors now have only about half the returns of Total Market Investors. This is terrible underperformance based on earlier returns.

Combining the Total Stock Market with Small Cap Value" substantially reduced "risk-adjusted returns".

Best wishes.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by snailderby »

bikechuck wrote: Tue Oct 20, 2020 2:29 pm
sleepysurf wrote: Tue Oct 20, 2020 1:57 pm
vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
Another option is to add a slice of Vanguards Extended Market Index (VEXAX) which comprises the Total Market minus the S&P 500, thus a Mid and Small Cap "size tilt." However, being market-cap weighted, it doesn't offer any "value tilt" if OP is so inclined.
Thanks, if you add VEXAX to an S&P 500 fund would you essentially have the equivalent of a U.S. Total Market Fund?

I suppose that if you added it to a total market fund you would thin out the disproportionate impact of the largest ten companies and you would do so with both small and mid cap companies so this is something to consider that I would not have thought of on my own so I appreciate your post.
Extended market funds like VEXAX also hold large cap companies that are not part of the S&P 500 index, like Tesla. So yes, VEXAX would be a great complement to a S&P 500 fund. But if your goal is to add more midcaps or small caps to a total stock market fund, I would use an actual midcap or small cap fund instead. Unless you're OK with selectively overweighting a few large companies like Tesla along with tilting to true midcaps and small caps.
Last edited by snailderby on Tue Oct 20, 2020 3:58 pm, edited 1 time in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by mickeyd »

Own the entire market and reap what it gives you. STC
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by TheoLeo »

At least when backtesting, 100 % total US market vs. 50% small cap US plus 50 % total US market practically amounts to the same from 1972 to today. If you truly want to diversify, maybe you should add something that isnt as correlated with the total market. So small cap value or emerging markets.
Last edited by TheoLeo on Tue Oct 20, 2020 4:00 pm, edited 1 time in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by rich126 »

This would defeat your simplicity/low cost goals but there are funds like RSP that equal weights the SP500 instead of cap weight. At times it does better than the SP500 and currently it is lagging due to the tech stock/top heavy stocks in the SP500 sizable out performance over the last year or two.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by nisiprius »

rich126 wrote: Tue Oct 20, 2020 4:00 pm This would defeat your simplicity/low cost goals but there are funds like RSP that equal weights the SP500 instead of cap weight. At times it does better than the SP500 and currently it is lagging due to the tech stock/top heavy stocks in the SP500 sizable out performance over the last year or two.
But it isn't equal weighting. There are about 3,500 stocks in the stock market. Explain to me the logic investing, say, $100.00 into each of 500 of them and $0.00 into 3,000 of them.

When you are cap-weighting, even if you would really like to hold the whole market, you can still say that the S&P 500 captures 80% it. But if you are equal-weighting, 500 stocks only captures 1/7th of the market. To get the same 80% of the market at equal weight, you'd need to hold 2,800 stocks.

There is no logic behind an equal-weighted S&P 500. If it is logical to weight equally, then it is illogical to hold only 500 stocks. All there is behind the equal-weighted S&P 500 is past performance. It is illusory outperformance, the result of taking more risk. If you adjust for risk the equal-weighted S&P has underperformed.

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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Uncorrelated »

vineviz wrote: Tue Oct 20, 2020 3:01 pm
Uncorrelated wrote: Tue Oct 20, 2020 1:36 pm According to research from AQR based on Fama/French 3 model, the SmB factor does not have positive alpha. It is my belief that if one "improves diversification", that should show up as alpha in a CAPM model, but there is none. How do you explain that?
Alpha is not an effective way to measuring diversification, for two reasons:

1) A factor regression of a rebalanced portfolio simply produces the arithmetic mean factor exposures of the constituent asset returns, so fails to capture any diversification benefits (which are measured using geometric and harmonic means, not arithmetic means).
....What?

Diversification is a way of reducing Idiosyncratic risk. Geometric and harmonic means are measures of risk-adjusted return, not risk. Volatility and skew are measures of risk. If we have an asset with the same return sequence as mkt except that we zero out a single loss day from history (= less risk!), it will show up as positive alpha when regressed against mkt.
A portfolio which is 50% stocks and 50% intermediate Treasuries is more diversified than a portfolio of 100% stocks, but obviously the diversified portfolio has lower expected returns than the concentrated portfolio.
A portfolio of 50% stocks / 50% ITT does not have less risk than a 100% stock portfolio. It has different risks, that is multi factor diversification. AQR tried really, really hard to show over-weighting small caps has benefits, but they simply found no evidence at all (in a 3 factor world).

https://www.aqr.com/Insights/Research/J ... ize-Effect
The easiest way to observe a gain in diversification is to
Sorry, I demand stronger evidence. For example, show that we have two portfolio's:
- Total stock market + overweight small cap with an HmL exposure of 0.
- Total stock market scaled to the same expected return as the portfolio above.
The former has statistically significant less risk.

Then once you have shown this, show that this effect has a plausible explanation. For example, show that the above is still true when the efficient market starts over-weighting small caps. Or, provide a compelling risk-based explanation why the efficient market isn't going to do that.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by arcticpineapplecorp. »

you don't have to do anything. the market mitigates itself. look at how over a 24 year period (1994-2018) big companies became smaller and small companies became larger:

https://americanbusinesshistory.org/lar ... 1994-2018/

funny thing is the market grew anyway. don't take my word for it see for yourself:

Image

source:
http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

now what's the problem again?
It's "Stay" the course, not Stray the Course. Buy and Hold works. You should really try it sometime. Get a plan: www.bogleheads.org/wiki/Investment_policy_statement
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by 000 »

KlangFool wrote: Tue Oct 20, 2020 10:54 am OP,


A tilt to SCV and Active Management. I do both.

A) 10% of my portfolio is in the SCV pair with another 10% in the Intermediate-Term Treasury as part of my mini-Larry Portfolio.


B) 40% of my portfolio is in the actively managed Wellington Fund (65/35).


C) Only 40% of my portfolio is in the 3-funds.


KlangFool

P.S.: My overall AA is 60/40.
This is probably a good of thread as any to ask this... aren't your sub-portfolios mostly cancelling each other out?

mini-Larry tilts small but Wellington tilts large, cancelling out the size tilt.

mini-Larry tilts Treasures but Wellington tilts Corporate bonds, averaging out to something like Total bond.

You basically just have a three fund portfolio with a very mild value tilt (Wellington is slightly value tilted, SCV is obvious).
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by sycamore »

nisiprius wrote: Tue Oct 20, 2020 2:38 pm
sycamore wrote: Tue Oct 20, 2020 2:03 pm...Several responses have noted that the are always a relatively few heavily weighted stocks in cap-weighted indices. But they are not always as sector-concentrated as now, with the FAANG stocks dominant...
Things vary all the time. In 1980, seven of the top ten were Exxon, Standard Oil of Indiana, Schlumberger, Shell Oil, Mobil, Standard Oil of California, and Atlantic Richfield. It was more concentrated in energy companies then than it is in tech now. If CNBC had existed someone probably would have been saying "it's not Wall Street any more, it's SSSSAME Street."

The idea behind indexing is to mirror the stock market as it is. When the market is putting more of its money in tech, you are doing the same thing. When it is putting more of its money in oil companies, you are doing the same thing. You are doing whatever the market does.

There's no magic here but doing this has a number of good points that need to be weighed along with the bad. The plan of mirroring the market may mean you have a lot of money in a few stocks, but it also means that you were invested in these companies all the way up as they made it into the top ten.

And the burden of proof is on those who suggest there is something so wrong with that, that sticking to it is a bad plan.
Minor note: the quoted section saying "sycamore wrote" above was actually from statman. My earlier comment was that if you're trying to find a fund unlike TSM in some way, need to look under the covers to see how different it really is.

I agree with the comments from nisiprius, especially about the change in top 10 and sector concentration -- take that as a given, and get used to the idea of companies rising and falling over time.

In my case, I invest in total stock market and also tilt to certain parts of the market. I don't recommend this to anyone so I won't be offering any proof - it's very much a case of a "personal finance" decision and me being comfortable with the stock asset allocation.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Portfolio7 »

bikechuck wrote: Tue Oct 20, 2020 10:38 am As I age and simplify my portfolio I love the idea of reducing my equity holdings to a single total stock market index fund. However I have concerns about the fact that in most of these funds 10 large companies compromise 20% of the fund value which reduces the diversification objective.

Diversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.

Thanks in advance for your thoughts.
I'm not sure you should be afraid of that concentration. It's reasonably stable. It's not much different than it's always been, little more than the names have changed, neh? Do you have problems staying the course with TSM? If not, I'd stick with it.

I have my US Stocks split about 29% Large Cap, 29% Mid Cap, 29% Small Cap, 13% REITs. I'm not going to try to show anyone that it's the best approach. (I don't trust that the statistics are accurate enough to measure the risk, for example. Stock returns don't form a normal distribution.) However, it works well enough for me. The real question is: what portfolio are you most comfortable with in bad times (& good), so that you don't sell when you should be staying the course? That's the right portfolio for you.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by averagedude »

The return driver of your portfolio will not be how much large vs small, or value vs growth, or domestic vs international. The return driver will most likely be from your asset allocation between stocks and fixed income.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Uncorrelated wrote: Tue Oct 20, 2020 4:22 pm Geometric and harmonic means are measures of risk-adjusted return, not risk.
Mean returns are just that: average measures of return. There’s nothing “risk-adjusted” about them regardless of which type you mean you compute.
If we have an asset with the same return sequence as mkt except that we zero out a single loss day from history (= less risk!), it will show up as positive alpha when regressed against mkt.
That’s because you’ve intentionally created a new data series with positive alpha. It’s a problematic example because you’ve transformed the mean return, the variance, and the correlation all at once.

The closer you stay to first principles the easier it is to understand what goes into diversification and what comes out of it.

What happens when you combine two uncorrelated assets with identical return distributions (eg normal distributions with the same mean and standard deviation)?

You get a portfolio with the same arithmetic mean return as each asset, but greater geometric mean return than either one and a lower volatility than either one. That’s diversification.

And if you run a factor regression on the combined portfolio, you’ll find no added alpha. Why? Because the arithmetic mean return is not improved, only the geometric mean return.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Uncorrelated wrote: Tue Oct 20, 2020 4:22 pm
vineviz wrote: Tue Oct 20, 2020 3:01 pm A portfolio which is 50% stocks and 50% intermediate Treasuries is more diversified than a portfolio of 100% stocks, but obviously the diversified portfolio has lower expected returns than the concentrated portfolio.
A portfolio of 50% stocks / 50% ITT does not have less risk than a 100% stock portfolio. It has different risks, that is multi factor diversification. AQR tried really, really hard to show over-weighting small caps has benefits, but they simply found no evidence at all (in a 3 factor world)
1) I didn't say that a portfolio 50% stocks / 50% ITT has "less risk than a 100% stock portfolio". I said it was more diversified, which you seem to agree is true.

2) AQR has written a couple of papers about the size factor, and it isn't accurate to summarize ANY of them as concluding there is no benefit to over-weighting small caps. That's true even in a three factor world, but even more true in a world which includes quality.

3) Notably, there is not need for there to be any evidence that size is a statistically significant factor in order for there to be diversification benefits from overweighting small cap stocks. Virtually any strategy that reduces the percentage of the portfolio that is allocated to the ten largest stocks in the market is going to improve diversification, simply because those ten companies are creating such a significant amount of idiosyncratic risk due to their large weights.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KlangFool »

000 wrote: Tue Oct 20, 2020 5:16 pm
KlangFool wrote: Tue Oct 20, 2020 10:54 am OP,


A tilt to SCV and Active Management. I do both.

A) 10% of my portfolio is in the SCV pair with another 10% in the Intermediate-Term Treasury as part of my mini-Larry Portfolio.


B) 40% of my portfolio is in the actively managed Wellington Fund (65/35).


C) Only 40% of my portfolio is in the 3-funds.


KlangFool

P.S.: My overall AA is 60/40.
This is probably a good of thread as any to ask this... aren't your sub-portfolios mostly cancelling each other out?

mini-Larry tilts small but Wellington tilts large, cancelling out the size tilt.

mini-Larry tilts Treasures but Wellington tilts Corporate bonds, averaging out to something like Total bond.

You basically just have a three fund portfolio with a very mild value tilt (Wellington is slightly value tilted, SCV is obvious).
000,

No.

A) Wellington fund is actively managed on both the stock and the bond side. So, it is not related to the 3-funds aka passive index.


B) SCV and Treasury are passive index funds.


KlangFool
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by 000 »

KlangFool wrote: Tue Oct 20, 2020 7:17 pm 000,

No.

A) Wellington fund is actively managed on both the stock and the bond side. So, it is not related to the 3-funds aka passive index.


B) SCV and Treasury are passive index funds.


KlangFool
I agree that Wellington's active management adds another layer of difference, but Wellington is and has for a long time been large cap stocks + more corporate bonds than TBM. So it still seems to partially cancel out the SCV + Treasuries.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KlangFool »

000 wrote: Tue Oct 20, 2020 7:25 pm
KlangFool wrote: Tue Oct 20, 2020 7:17 pm 000,

No.

A) Wellington fund is actively managed on both the stock and the bond side. So, it is not related to the 3-funds aka passive index.


B) SCV and Treasury are passive index funds.


KlangFool
I agree that Wellington's active management adds another layer of difference, but Wellington is and has for a long time been large cap stocks + more corporate bonds than TBM. So it still seems to partially cancel out the SCV + Treasuries.

000,


I am counting on the Wellington Fund to buffer me from this recession. I am not all sold on passive indexing. I learned my lesson from Telecom and DotCom Bust. The market can and do go crazy some times.


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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by absolute zero »

000 wrote: Tue Oct 20, 2020 7:25 pm
KlangFool wrote: Tue Oct 20, 2020 7:17 pm 000,

No.

A) Wellington fund is actively managed on both the stock and the bond side. So, it is not related to the 3-funds aka passive index.


B) SCV and Treasury are passive index funds.


KlangFool
I agree that Wellington's active management adds another layer of difference, but Wellington is and has for a long time been large cap stocks + more corporate bonds than TBM. So it still seems to partially cancel out the SCV + Treasuries.
I got bored and ran PV factor regression out of curiosity. The Wellington and SCV ratio that Klangfool specified does, in fact, neutralize any tilt to small (at least assuming he’s using VBR/VSIAX). Factor loading of -0.01. As you mentioned, he still gets value exposure out of it though.

https://www.portfoliovisualizer.com/fa ... tion2_1=20
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by 000 »

absolute zero wrote: Tue Oct 20, 2020 7:36 pm I got bored and ran PV factor regression out of curiosity. The Wellington and SCV ratio that Klangfool specified does, in fact, neutralize any tilt to small (at least assuming he’s using VBR/VSIAX). Factor loading of -0.01. As you mentioned, he still gets value exposure out of it though.

https://www.portfoliovisualizer.com/fa ... tion2_1=20
Thanks. I guess it might actually make sense if a person wants Wellington and a value tilt without the size tilt.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by 000 »

KlangFool wrote: Tue Oct 20, 2020 7:31 pm I am counting on the Wellington Fund to buffer me from this recession. I am not all sold on passive indexing. I learned my lesson from Telecom and DotCom Bust. The market can and do go crazy some times.
What are your thoughts on some of the other active funds managed by Wellington, e.g. Windsor, Dividend Growth?
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