Nondiversification Risk - Vanguard 500 Index Fund

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nps
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Nondiversification Risk - Vanguard 500 Index Fund

Post by nps »

Just over a week ago, Vanguard posted a supplement to its 500 Index Fund prospectus that added "nondiversification risk" and "sector risk" to the list of principal risks to the fund's performance.
Nondiversification risk. Because the Fund seeks to closely track the composition of the Fund’s target index, from time to time, more than 25% of the Fund’s total assets may be invested in issuers representing more than 5% of the Fund’s total assets due to an index rebalance or market movement, which would result in the Fund being nondiversified under the Investment Company Act of 1940. The Fund’s performance may be hurt disproportionately by the poor performance of relatively few stocks, or even a single stock, and the Fund’s shares may experience significant fluctuations in value.
Sector risk, which is the change that significant problems will affect a particular sector, or that returns from that sector will trail returns from the overall stock market. Daily fluctuations in specific market sectors are often more extreme or volatile than fluctuations in the overall market. Because a significant portion of the Fund’s assets are invested in the information technology sector, the Fund’s performance is impacted by the general condition of that sector. Companies in the information technology sector could be affected by, among other things, overall economic conditions, short product cycles, rapid obsolescence of products, competition, and government regulation. Sector risk is expected to be high for the Fund.
There have been several recent threads about the increasing concentration of the broad US market. There have also been replies suggesting this is nothing unusual. But it's interesting to see that Vanguard now believes it necessary to include these additional risks when it has not done so in the past.

Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by exodusNH »

nps wrote: Sat Jul 06, 2024 12:33 pm Just over a week ago, Vanguard posted a supplement to its 500 Index Fund prospectus that added "nondiversification risk" and "sector risk" to the list of principal risks to the fund's performance.
Nondiversification risk. Because the Fund seeks to closely track the composition of the Fund’s target index, from time to time, more than 25% of the Fund’s total assets may be invested in issuers representing more than 5% of the Fund’s total assets due to an index rebalance or market movement, which would result in the Fund being nondiversified under the Investment Company Act of 1940. The Fund’s performance may be hurt disproportionately by the poor performance of relatively few stocks, or even a single stock, and the Fund’s shares may experience significant fluctuations in value.
Sector risk, which is the change that significant problems will affect a particular sector, or that returns from that sector will trail returns from the overall stock market. Daily fluctuations in specific market sectors are often more extreme or volatile than fluctuations in the overall market. Because a significant portion of the Fund’s assets are invested in the information technology sector, the Fund’s performance is impacted by the general condition of that sector. Companies in the information technology sector could be affected by, among other things, overall economic conditions, short product cycles, rapid obsolescence of products, competition, and government regulation. Sector risk is expected to be high for the Fund.
There have been several recent threads about the increasing concentration of the broad US market. There have also been replies suggesting this is nothing unusual. But it's interesting to see that Vanguard now believes it necessary to include these additional risks when it has not done so in the past.

Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
They're adding the risk disclosures because they are required to by law, which they cite.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by BitTooAggressive »

exodusNH wrote: Sat Jul 06, 2024 12:51 pm
nps wrote: Sat Jul 06, 2024 12:33 pm Just over a week ago, Vanguard posted a supplement to its 500 Index Fund prospectus that added "nondiversification risk" and "sector risk" to the list of principal risks to the fund's performance.
Nondiversification risk. Because the Fund seeks to closely track the composition of the Fund’s target index, from time to time, more than 25% of the Fund’s total assets may be invested in issuers representing more than 5% of the Fund’s total assets due to an index rebalance or market movement, which would result in the Fund being nondiversified under the Investment Company Act of 1940. The Fund’s performance may be hurt disproportionately by the poor performance of relatively few stocks, or even a single stock, and the Fund’s shares may experience significant fluctuations in value.
Sector risk, which is the change that significant problems will affect a particular sector, or that returns from that sector will trail returns from the overall stock market. Daily fluctuations in specific market sectors are often more extreme or volatile than fluctuations in the overall market. Because a significant portion of the Fund’s assets are invested in the information technology sector, the Fund’s performance is impacted by the general condition of that sector. Companies in the information technology sector could be affected by, among other things, overall economic conditions, short product cycles, rapid obsolescence of products, competition, and government regulation. Sector risk is expected to be high for the Fund.
There have been several recent threads about the increasing concentration of the broad US market. There have also been replies suggesting this is nothing unusual. But it's interesting to see that Vanguard now believes it necessary to include these additional risks when it has not done so in the past.

Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
They're adding the risk disclosures because they are required to by law, which they cite.
Exactly.

Since I also own VXUS, VTV, AVDV and AVUV concentration in the SP500 or US total market does not concern me.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by tarantula13 »

I think it should be a wake up call to S&P 500 only investors, but there's a reason why you should track the small/mid cap companies as well as international in the stock holding of your portfolio.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Johnnie »

I'm not sure the problem is limited to the S&P 500: Is the capitalization of the "Mag Seven" etc. now so outsized that the issue is relevant even to Total Market funds at VG and others?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by KlangFool »

OP,

It is only a problem for someone that are 100% S&P 500. Good luck to them!

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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by nps »

exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by IDpilot »

nps wrote: Sat Jul 06, 2024 9:18 pm
exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Beensabu »

IDpilot wrote: Sat Jul 06, 2024 9:33 pm
nps wrote: Sat Jul 06, 2024 9:18 pm
exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
In what alternate universe is the Investment Company Act of 1940 a new regulation?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gammalaser »

IDpilot wrote: Sat Jul 06, 2024 9:33 pm
nps wrote: Sat Jul 06, 2024 9:18 pm
exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
Why does government regulator need to "address" this? This is a disclosure requirement for the benefit of the investor.

It is also indeed a wakeup call. Think about the retirement plans which are invested in S&P 500 only due to lack of total market fund. There may be other funds available in such plans such as small/mid cap specific funds to add diversification, but folks may have steered away from holding more than one equity fund for simplification. Now, if you take such disclosure at face value, having only S&P 500 is not enough to be diversified.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by IDpilot »

Beensabu wrote: Sat Jul 06, 2024 10:09 pm
IDpilot wrote: Sat Jul 06, 2024 9:33 pm
nps wrote: Sat Jul 06, 2024 9:18 pm
exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
In what alternate universe is the Investment Company Act of 1940 a new regulation?
The relevant law has not changed but how the SEC interrupts and enforces that law has for indexed funds. The Investment Company Act requires a fund declare whether it will operate as a diversified company or not in its registration statement. It also requires that once that fund is registered it can only change its classification from diversified to non-diversified unless authorized by a vote of a majority of its outstanding voting securities. Certain index funds that provided specified notices to their shareholders are now exempt from this requirement.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by AlohaBill »

I do not care one iota about my investments in Vanguard’s S and P 500 fund. This smacks of fear mongering. I am blatantly, blissfully unaware of any problems that may or may not happen in the future. Sometimes, I blissfully unaware of my grandchildren’s names. You will find yourself in this position in the not too distant future. Life is good, but short.😇
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by exodusNH »

nps wrote: Sat Jul 06, 2024 9:18 pm
exodusNH wrote: Sat Jul 06, 2024 12:51 pm They're adding the risk disclosures because they are required to by law, which they cite.
Sure, but it's never before been a problem they felt required to address
They didn't have to because the thresholds hadn't been reached.

There are lots of laws that don't apply to companies employing people below certain thresholds. E.g., at 15 people, antidiscrimination laws take effect. If you suddenly see posters in the kitchen talking about this, you can't draw the conclusion that they were discriminating before. They're just reached the threshold dictated by law.

You have to draw a line somewhere. At 17 years and 364 days, you are not a fundamentally different person than at 18 years and 0 days, but a whole new set of laws kicked in.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rockstar »

If this really bothers the OP, then check out equal weighted S&P 500 index funds as an alternative. Nobody is making you buy a market weighted S&P 500 index fund.

Here's RSP:

https://www.invesco.com/us/financial-pr ... ticker=RSP

But you'll pay 20bps of ER for it, which is much more expensive than VOO at 3bps. And you'll receive a much higher dividend yield.
Last edited by rockstar on Sun Jul 07, 2024 11:41 am, edited 1 time in total.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by sycamore »

This topic is germane to many large cap funds, not just the Vanguard 500 but many S&P 500 or large blend/growth funds.

For example
T. Rowe Price says about its 500 tracker fund:
The fund may become nondiversified, as defined under the Investment Company Act of 1940, solely as a result of a change in relative market capitalization or index weighting of one or more constituents of the Index.
And a 2023 Morningstar article about it: How Large-Growth Funds Are Navigating Their Concentrated Universe.

I agree with those saying it's not the fund manager making a qualitative judgement about anything.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by nisiprius »

My strategy was and is that I wanted to mirror the market. Period.

My strategy was not, and is not, "mirror the market as long as it is acting the way I think it should, and make intuitive departures from the market when the market feels wrong to me."

Within this forum, there seems to be rough parity between those who say "OMG, too much tech in the S&P 500" and those who say "tech is the future, the tech sector is destined to outperform the rest of the market forever, why own anything else?" So I'll just shrug and stay the course.

Even if the S&P 500 index fund violates the 75-5-10 rule, it will be a while before the total market fund does, and even longer before my own portfolio, which, within stocks, is 80% Total Stock Market and 20% Total International.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gammalaser »

Maybe regulatory definition of diversification needs changing to account for market weighting.

And I think this issue is less important for those who have DIY portfolio and more an issue for someone who may need an advisor to answer: why does market weight ETF have this nondiversification risk and equal weight does not?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by intendi »

Technology sector weighting:
  • Vanguard S&P 500 ETF (VOO) 31.52%
  • Vanguard Total Stock Market Index Fund ETF Shares (VTI) 29.97%
  • Vanguard Total World Stock Index Fund ETF Shares (VT) 23.73%
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Rocinante Rider »

nps wrote: Sat Jul 06, 2024 12:33 pm Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks
Not at all. I feel absolutely the same and sanguine about my passive, total market, cap-weighted indexing.

For the stock portion of my portfolio I own cap weighted pieces of the entire US market and of the entire world: 75-80% in total US market and 20-25% in total international market. If one or more companies periodically dominate the stock universe and the global economy, why should I feel differently and shift towards a non-cap weighted approach? Non-cap weighted investing would also require active trading and all its attendant costs. I'm not concerned about the risks, new or otherwise, of owning the world according to its prevailing valuations. Indexing has many beauties, including not having to worry about the constant evolution of which companies dominate at any given moment. I always own them proportional to their place in the market.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Florida Orange »

Johnnie wrote: Sat Jul 06, 2024 5:50 pm I'm not sure the problem is limited to the S&P 500: Is the capitalization of the "Mag Seven" etc. now so outsized that the issue is relevant even to Total Market funds at VG and others?
Yes, it is. But if you're in an S&P 500 fund and you're worried about it, you can mitigate the risk by diversifying. You could add an extended market fund or switch to a total market fund. If you're already in a total market fund the problem still affects you, but what can you do about it? Not much, I don't think, except invest in something other than stocks if you're that worried about it.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Rocinante Rider »

If the parameter is "don't own an index fund if a single company comprises more than 5% of the total value," does one sell if two companies that each comprise 4% of the value merge? Is it okay to buy the fund again if the merged companies subsequently re-separate? Is an index that includes a megacap conglomerate not okay, but it becomes okay if the conglomerate breaks up into pieces that don't alter the composite value? Is there a better alternative to just owning the entire universe of stocks according to their current valuations?

Actively managed funds in aggregate also own their benchmark indices in exactly the same concentrations as index funds. One could seek out only those funds that skew towards lower valuation holdings, but active management of any sort has not been a winning strategy.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gammalaser »

I am curious what are some more practical implications of this. For example, could fiduciaries, pension plans, etc., be liable if they suggested solely an S&P 500 index fund for diversification rather than total market fund?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rule of law guy »

tarantula13 wrote: Sat Jul 06, 2024 1:46 pm I think it should be a wake up call to S&P 500 only investors, but there's a reason why you should track the small/mid cap companies as well as international in the stock holding of your portfolio.
wake up call? nah, I am hitting the snooze button
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Hacksawdave »

I have owned index funds since 1997. I have always known that several popular stocks at the time measured will represent a significant portion of the S&P 500 at any given time, and change over time. Sector risk is not a new disclosure. I have the prospectus for VFIAX from 2014 and it includes:

Market Exposure
The Fund is subject to stock market risk, which is the chance that stock prices
overall will decline. Stock markets tend to move in cycles, with periods of
rising prices and periods of falling prices. The Fund’s target index tracks a
subset of the U.S. stock market, which could cause the Fund to perform
differently from the overall stock market. In addition, the Fund’s target index
may, at times, become focused in stocks of a particular market sector, which
would subject the Fund to proportionately higher exposure to the risks of
that sector.


This is of no concern to me because I have been hearing this argument for over a decade. What would be the alternative, active management? I know what I am buying and holding.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rkhusky »

Focus on the overall technologies, products, brands, market share, etc, that you own, not on how it is divvied up by stock market ticker.

Should I really care if technology X is included in ticker A vs ticker B or is it more important that my portfolio includes X?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gavinsiu »

The index does have a high concentration on tech stock. However, it's still more diverified than investing in 10 different stocks. You can diversified further by tiling small cap, or buying international or bonds. However, doing so in the last 20 years or so would have resulted in reduced return. You can also get a different index such as SCHD, which probably has less tech heavy allocation, but probably is less tax efficient and lower return.

You either take the risk and stock with Vanguard 500 or Total Stock or try to diversified it with other assets, but many won't do it because they feel the other choices have lower returns.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Beensabu »

gammalaser wrote: Sun Jul 07, 2024 1:13 pm Maybe regulatory definition of diversification needs changing to account for market weighting.
Or maybe people need to recognize that market cap weighting can at times result in nondiversification and the potential consequences of that (which apply to index funds just as they do to active funds), so they are not taken by surprise that such a thing could ever happen.

If I said that 20% of my equity portfolio consisted of 3 individual stocks, BHdom would be all over telling me how I should diversify into a total market or S&P 500 index fund to mitigate idiosyncratic risk and be sure to limit my "fun money" to 5% of my port. But that's the reality of the current composition of the S&P 500 index - 20% of it is in 3 companies.

Edit: And the folks in VGT... 46% in 3 companies. Three (3). Nearly half of the fund (an index fund) is in 3 companies. That's bonkers.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by HanSolo »

nps wrote: Sat Jul 06, 2024 12:33 pm Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
No. Previously, I already thought the fund carried those risks (perhaps my personal threshold for "non-diversified" was lower than that in the 1940 act). Listing those risks in the fund description just makes that risk more visible to more audiences, which is probably a good thing. I don't see it as a "problem" in any case. They're just making a statement of fact (that the fund may go outside the definition of diversified according to the 1940 act). Stating a fact isn't a problem.
IDpilot wrote: Sun Jul 07, 2024 7:55 am
Beensabu wrote: Sat Jul 06, 2024 10:09 pm
IDpilot wrote: Sat Jul 06, 2024 9:33 pm And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
In what alternate universe is the Investment Company Act of 1940 a new regulation?
The relevant law has not changed but how the SEC interrupts and enforces that law has for indexed funds. The Investment Company Act requires a fund declare whether it will operate as a diversified company or not in its registration statement. It also requires that once that fund is registered it can only change its classification from diversified to non-diversified unless authorized by a vote of a majority of its outstanding voting securities. Certain index funds that provided specified notices to their shareholders are now exempt from this requirement.
I'm not seeing anything online that confirms your assertions. If you think Vanguard's wording was caused by some recent change on the part of the SEC or anyone else in the government, please cite the change and when it came into effect.
AlohaBill wrote: Sun Jul 07, 2024 9:07 am I do not care one iota about my investments in Vanguard’s S and P 500 fund. This smacks of fear mongering.
Not really. Yours is the first indication that any fear is involved. Every fund has various risks which are listed in the fund prospectus (appropriately). I simply choose which risks I want or don't want. I don't fear them.
Rocinante Rider wrote: Sun Jul 07, 2024 3:03 pm If the parameter is "don't own an index fund if a single company comprises more than 5% of the total value," does one sell if two companies that each comprise 4% of the value merge? Is it okay to buy the fund again if the merged companies subsequently re-separate? Is an index that includes a megacap conglomerate not okay, but it becomes okay if the conglomerate breaks up into pieces that don't alter the composite value? Is there a better alternative to just owning the entire universe of stocks according to their current valuations?
I think the answer is that those who want to take the suggested actions will take them, and those who don't, won't. It doesn't say anything about what you should do. I'll just add that the merged company can be brought down by one corrupt C-suite, which would be less likely to happen to both of the two separate companies. I'm not saying this means you should take any particular action. You should do what you want. I hope that answers your question.
Actively managed funds in aggregate also own their benchmark indices in exactly the same concentrations as index funds. One could seek out only those funds that skew towards lower valuation holdings, but active management of any sort has not been a winning strategy.
There's nothing in the OP saying anything about active vs. indexed. Whether one should own active funds is a different topic (I own both active and indexed). If one is concerned about VOO having sector risk, they could also own other index funds (such as VTV and others mentioned upthread). Some people were already doing that before the aforementioned wording showed up. It's not a problem.

People invest in what they want. If different people want different things, it doesn't mean there's a problem.
Beensabu wrote: Sun Jul 07, 2024 10:44 pm
gammalaser wrote: Sun Jul 07, 2024 1:13 pm Maybe regulatory definition of diversification needs changing to account for market weighting.
Or maybe people need to recognize that market cap weighting can at times result in nondiversification and the potential consequences of that (which apply to index funds just as they do to active funds), so they are not taken by surprise that such a thing could ever happen.
This. There's no reason to change the regulatory definition, because it's not causing a problem.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by nisiprius »

Is "non-diversified" merely a warning label, or are there regulations restricting what kinds of funds are eligible for various purposes?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by aristotelian »

rockstar wrote: Sun Jul 07, 2024 10:48 am If this really bothers the OP, then check out equal weighted S&P 500 index funds as an alternative. Nobody is making you buy a market weighted S&P 500 index fund.

Here's RSP:

https://www.invesco.com/us/financial-pr ... ticker=RSP

But you'll pay 20bps of ER for it, which is much more expensive than VOO at 3bps. And you'll receive a much higher dividend yield.
In recent history it has also underperformed the S&P with more volatility. I could live with one or the other but not both. Maybe that changes but so far it has failed to counter concentration risk for those who are looking to reduce volatility.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by BrooklynInvest »

nps wrote: Sat Jul 06, 2024 12:33 pm
Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
I don't think the risks aren't new. Concentration risk is perhaps slightly elevated from what it was in the past so Vanguard's compliance officer felt it prudent to more prominently disclose the risk. A good thing for investors to be aware of but that's it. Business as usual. My asset allocation still aligns with my risk tolerance.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by toddthebod »

BrooklynInvest wrote: Mon Jul 08, 2024 7:07 am
nps wrote: Sat Jul 06, 2024 12:33 pm
Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
I don't think the risks aren't new. Concentration risk is perhaps slightly elevated from what it was in the past so Vanguard's compliance officer felt it prudent to more prominently disclose the risk. A good thing for investors to be aware of but that's it. Business as usual. My asset allocation still aligns with my risk tolerance.
Again, it's not about prudence or a decision by Vanguard other than their decision to follow the law.

It's like going to Starbucks for 20 years in your hometown then visiting a branch in California and seeing the Prop 65 warning on the door and thinking you will now get cancer.
IDpilot
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by IDpilot »

HanSolo wrote: Mon Jul 08, 2024 3:15 am
IDpilot wrote: Sun Jul 07, 2024 7:55 am
Beensabu wrote: Sat Jul 06, 2024 10:09 pm
IDpilot wrote: Sat Jul 06, 2024 9:33 pm And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
In what alternate universe is the Investment Company Act of 1940 a new regulation?
The relevant law has not changed but how the SEC interrupts and enforces that law has for indexed funds. The Investment Company Act requires a fund declare whether it will operate as a diversified company or not in its registration statement. It also requires that once that fund is registered it can only change its classification from diversified to non-diversified unless authorized by a vote of a majority of its outstanding voting securities. Certain index funds that provided specified notices to their shareholders are now exempt from this requirement.
I'm not seeing anything online that confirms your assertions. If you think Vanguard's wording was caused by some recent change on the part of the SEC or anyone else in the government, please cite the change and when it came into effect.
https://www.sec.gov/investment/stradley-062419

https://www.sec.gov/divisions/investmen ... coming.pdf
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Rocinante Rider »

IDpilot wrote: Mon Jul 08, 2024 7:41 am
HanSolo wrote: Mon Jul 08, 2024 3:15 am
IDpilot wrote: Sun Jul 07, 2024 7:55 am
Beensabu wrote: Sat Jul 06, 2024 10:09 pm
IDpilot wrote: Sat Jul 06, 2024 9:33 pm And just because they have now addressed non-diversification when required by a new regulation does not mean that Vanguard feels like they need to address this risk. All we can say for sure is that some government regulator feels like they need to address this risk.
In what alternate universe is the Investment Company Act of 1940 a new regulation?
The relevant law has not changed but how the SEC interrupts and enforces that law has for indexed funds. The Investment Company Act requires a fund declare whether it will operate as a diversified company or not in its registration statement. It also requires that once that fund is registered it can only change its classification from diversified to non-diversified unless authorized by a vote of a majority of its outstanding voting securities. Certain index funds that provided specified notices to their shareholders are now exempt from this requirement.
I'm not seeing anything online that confirms your assertions. If you think Vanguard's wording was caused by some recent change on the part of the SEC or anyone else in the government, please cite the change and when it came into effect.
https://www.sec.gov/investment/stradley-062419

https://www.sec.gov/divisions/investmen ... coming.pdf
Thanks for the links.

In its response the Chief Counsel's Office gives this qualification: "You represent that each Affected Index was created by an index provider that is not an affiliated person of the index-based fund, its investment adviser or principal underwriter, or an affiliated person of such persons, and was not created solely for the index-based fund or its affiliated persons."

I wonder what the implications might be for Fidelity's Zero funds. My understanding is that those funds track proprietary indices created and used exclusively by and for Fidelity. Even though Fidelity's private indices effectively track third party indices, they still would not appear to comply with the conditions stated in the opinion letter. Does Fidelity list its Zero funds as non-diversified?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rockstar »

aristotelian wrote: Mon Jul 08, 2024 6:58 am
rockstar wrote: Sun Jul 07, 2024 10:48 am If this really bothers the OP, then check out equal weighted S&P 500 index funds as an alternative. Nobody is making you buy a market weighted S&P 500 index fund.

Here's RSP:

https://www.invesco.com/us/financial-pr ... ticker=RSP

But you'll pay 20bps of ER for it, which is much more expensive than VOO at 3bps. And you'll receive a much higher dividend yield.
In recent history it has also underperformed the S&P with more volatility. I could live with one or the other but not both. Maybe that changes but so far it has failed to counter concentration risk for those who are looking to reduce volatility.
In taxable it has a bigger tax drag with a larger dividend. And of course, it’s going to perform worse. It should be by being less concentrated in the winners than a market weighted index. But it solves the OPs problem of concentration of the winners. It’s really up to them if they want to accept the caveats.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by grahamite »

Position limits are the major reason why active managers have majorly underperformed S&P 500 index funds over the last decade.

While trees do not grow to the sky (although this market cycle is certainly testing that theory!) much of equity market outperformance over bonds is attributable to a relatively small number of big winners.

Position limits mean prematurely pruning these trees before they can grow to their full size. Of course eventually the limits of growth are reached and followed by either flatlining or decline. But the US economy is sufficiently dynamic that a new cohort of winners will emerge to replace the old market leaders. This natural rebalancing process may result in a stretch of disappointing returns but over a long enough period it is more than made up for by the next bull market driven by the new set of winners.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by GaryA505 »

What about deworsification risk?
Get most of it right and don't make any big mistakes. All else being equal, simpler is better. Simple is as simple does.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by GaryA505 »

nisiprius wrote: Sun Jul 07, 2024 1:08 pm My strategy was and is that I wanted to mirror the market. Period.

My strategy was not, and is not, "mirror the market as long as it is acting the way I think it should, and make intuitive departures from the market when the market feels wrong to me."

Within this forum, there seems to be rough parity between those who say "OMG, too much tech in the S&P 500" and those who say "tech is the future, the tech sector is destined to outperform the rest of the market forever, why own anything else?" So I'll just shrug and stay the course.

Even if the S&P 500 index fund violates the 75-5-10 rule, it will be a while before the total market fund does, and even longer before my own portfolio, which, within stocks, is 80% Total Stock Market and 20% Total International.
Does 80/20 US /Intl stocks mirror the market? I thought the world stock market was more like 60/40.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by nps »

rockstar wrote: Mon Jul 08, 2024 9:32 am But it solves the OPs problem of concentration of the winners. It’s really up to them if they want to accept the caveats.
I don't have a problem with concentration in general. Market weighted investing means accepting the potential for concentration. What I hadn't considered before is whether there is a level of concentration that should cause me to reallocate my investments. This would be no different than an AA, but at a fund level.

The Investment Company Act of 1940 sets a concentration threshold for diversification as the point when a set of individual securities that each exceed 5% of the fund's value collectively comprise more than 25% of the fund's assets. It sounds like many who responded in this thread are comfortable breaching that without reallocating their investments. What about higher concentrations - can it ever be too much?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rockstar »

nps wrote: Mon Jul 08, 2024 11:27 am
rockstar wrote: Mon Jul 08, 2024 9:32 am But it solves the OPs problem of concentration of the winners. It’s really up to them if they want to accept the caveats.
I don't have a problem with concentration in general. Market weighted investing means accepting the potential for concentration. What I hadn't considered before is whether there is a level of concentration that should cause me to reallocate my investments. This would be no different than an AA, but at a fund level.

The Investment Company Act of 1940 sets a concentration threshold for diversification as the point when a set of individual securities that each exceed 5% of the fund's value collectively comprise more than 25% of the fund's assets. It sounds like many who responded in this thread are comfortable breaching that without reallocating their investments. What about higher concentrations - can it ever be too much?
QQQ has some rules for rebalancing when certain thresholds are hit. It had a special rebalancing last year. I’m not sure what the rules are for the S&P 500.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Beensabu »

nisiprius wrote: Mon Jul 08, 2024 6:03 am Is "non-diversified" merely a warning label, or are there regulations restricting what kinds of funds are eligible for various purposes?
It looks like a fund has to disclose in its registration statement whether it is "diversified" or "non-diversified". So either it meets the definition at outset or it doesn't.

If a diversified fund falls out of the regulatory definition of "diversified" simply due to market movements (and not due to a buy decision), then it doesn't lose its diversified status.

The whole point of that regulation is that if a fund calls itself "diversified", it should actually be what it says it is. So if it falls out of that temporarily, it makes sense to let people know. Otherwise, you'd be lying.

There are tax advantages to falling under the "diversified" definition in order to be considered a regulated investment company as well. So if a fund doesn't qualify for the year, that's probably something shareholders want to know.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Steven F »

Part of the reason for the Vangard SP500 fund (VOO) disclosures is related to how the S&P500 index is structured. The SP500 weights a share by its market capitalization. Meaning that companies like Apple, Navidia, and Amazon represent more of the funds value than a smaller companies. SoHigh market capitalization compares can represent 5% or more of the funds value.

In comparison there are equal weighted SP500 funds The ETF RSP for for example. Same 500 stocks but each only represent 0.24% of the fund value. Meaning Apple, Navidia, and Amazon have less of an effect on the share price of the fund. This can change the risk and and performance of the fund.

VOO average since inception market price return 14.5% Yield 1.32%

RSP averages since inception market price return 11.37% Yield 1.58%

An Equal weighted fund has higher yield but a lower average yearly price gain. This also means that a big move in one high market capitalization stock will cause a bigger change in the share price in a weighted fund While in the the equal weighted fund the the price change is smaller in the equal weighted fund. The higher yield also encourages investors to buy and hold a share longer further reducing market price swings.

The differences are more obvious when you compare Vanguard total market index (VTSAX) This fund has 3635 stocks and like the SP500 is also a weighted fund. As a consequence each stock represents between 0 and 0.1% of the funds value. All funds I have listed only invest in US stocks.

VTSAX average since inception market price return 8.31% yield 1.36%.

For this fund due to its broader market exposure the average yearly market price return is is the smallest while the yield is very close to VOO. Clearly increase diversification helps reduce the effect of one stock having a big move. Once thing that may not be obvious is that the all 3 only have US stocks. Meaning that these fund have greater risk associated with one economy while a global fund would be less impacted by poor performance of a single economy.
Last edited by Steven F on Mon Jul 08, 2024 12:00 pm, edited 2 times in total.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by arcticpineapplecorp. »

nps wrote: Sat Jul 06, 2024 12:33 pm Just over a week ago, Vanguard posted a supplement to its 500 Index Fund prospectus that added "nondiversification risk" and "sector risk" to the list of principal risks to the fund's performance.
Nondiversification risk. Because the Fund seeks to closely track the composition of the Fund’s target index, from time to time, more than 25% of the Fund’s total assets may be invested in issuers representing more than 5% of the Fund’s total assets due to an index rebalance or market movement, which would result in the Fund being nondiversified under the Investment Company Act of 1940. The Fund’s performance may be hurt disproportionately by the poor performance of relatively few stocks, or even a single stock, and the Fund’s shares may experience significant fluctuations in value.
There have been several recent threads about the increasing concentration of the broad US market. There have also been replies suggesting this is nothing unusual. But it's interesting to see that Vanguard now believes it necessary to include these additional risks when it has not done so in the past.

Do you feel differently about the proper role of broad US (S&P 500 or total market) asset classes in your portfolio given these apparent new risks - at least according to Vanguard?
Intendi addressed the sector concentration of S&P500 vs total stock and total world. Regarding the nondiversifiable risk:

The top 5 stocks of the S&P500 make up 25.28% of the fund (source: https://investor.vanguard.com/investmen ... omposition)

The top 5 stocks of the total US stock market index fund make up 21.97% of the fund (source: https://investor.vanguard.com/investmen ... omposition)

The top 5 stocks of the total world stock market index fund make up 13.39% of the fund (source: https://investor.vanguard.com/investmen ... omposition)

the S&P500 is not "the market".

one can have greater diversification (less concentration) by owning the total world stock market index fund.

when one holds fixed income, that continues to deconcentrate the impact on the largest 5 companies on the overall portfolio.

cursory view of the internet says in a mutual fund no more than 5% should be invested in any one company. The S&P500 already violates that (3 companies exceed that) and total stock market index fund does too (also 3 companies exceed that) but in VT there is no one company that makes up more than 5% of the fund. Microsoft makes up 3.72% of VT.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gammalaser »

I am reminded of the following article by Alan Roth Is a Cap-Weighted Index Fund Diversified? where he states:
Whether a cap-weighted total-stock index fund is the most diversified stock portfolio one can have is debatable, though I think it is.
Sounds like regulators (and perhaps folks on this thread) disagree.
Last edited by gammalaser on Mon Jul 08, 2024 12:03 pm, edited 1 time in total.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by rkhusky »

A market cap fund holds shares of companies in proportion to how many shares a company has issued relative to all shares in the market. Therefore, market cap funds do not need to buy/sell because of prices changes - the market cap tracks price changes automatically. When money flows into/out of such a fund, it goes into/out of shares in the same proportions.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by toddthebod »

nps wrote: Mon Jul 08, 2024 11:27 am The Investment Company Act of 1940 sets a concentration threshold for diversification as the point when a set of individual securities that each exceed 5% of the fund's value collectively comprise more than 25% of the fund's assets. It sounds like many who responded in this thread are comfortable breaching that without reallocating their investments. What about higher concentrations - can it ever be too much?
If AAPL or NVDA went to zero tomorrow, my portfolio would shrink maybe 2-3%. So what? Realistically maybe they just stop growing and eventually get passed by new companies. I wouldn't even notice.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Beensabu »

gammalaser wrote: Mon Jul 08, 2024 11:58 am Sounds like regulators (and perhaps folks on this thread) disagree.
If I told you I had 20% of my equity allocation in 3 stocks, would you consider my portfolio adequately diversified?
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Rocinante Rider »

Beensabu wrote: Mon Jul 08, 2024 1:23 pm
gammalaser wrote: Mon Jul 08, 2024 11:58 am Sounds like regulators (and perhaps folks on this thread) disagree.
If I told you I had 20% of my equity allocation in 3 stocks, would you consider my portfolio adequately diversified?
No if you held the stocks individually, but yes if you held them at that percentage as part of a 100% portfolio of cap weighted total market index funds.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by Beensabu »

Rocinante Rider wrote: Mon Jul 08, 2024 1:33 pm
Beensabu wrote: Mon Jul 08, 2024 1:23 pm
gammalaser wrote: Mon Jul 08, 2024 11:58 am Sounds like regulators (and perhaps folks on this thread) disagree.
If I told you I had 20% of my equity allocation in 3 stocks, would you consider my portfolio adequately diversified?
No if you held the stocks individually, but yes if you held them at that percentage as part of a 100% portfolio of cap weighted total market index funds.
Why does it matter if I hold the stocks individually or as part of a cap weighted index fund?

Either having 20% of your equity allocation in 3 stocks is considered adequately diversified or it is not.

A cap weighted index fund is not diversified just because it is a cap weighted index fund. Either it adequately reduces idiosyncratic risk or it does not.
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Re: Nondiversification Risk - Vanguard 500 Index Fund

Post by gavinsiu »

Beensabu wrote: Mon Jul 08, 2024 1:23 pm If I told you I had 20% of my equity allocation in 3 stocks, would you consider my portfolio adequately diversified?
Let's flip it around. So you have 80% total stock and 20% of that is in the 3 stock so you have 16% in 3 stock or may be 5% Suppose one of the companny went the ways of the Enron or Lehman Brothers, you would lose 5%, more if that stock is also in the 500 index.
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