"When It Comes to Diversification, Don't Be Naive"

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Taylor Larimore
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"When It Comes to Diversification, Don't Be Naive"

Post by Taylor Larimore »


For those who like to theorize about such things, Morningstar has an article discussing cap-weighted index funds favored by Vanguard vs. equal-weighted index funds favored by several other fund companies.. This is Morningstar's conclusion:
It's difficult to make a case for equal-weighted funds as they tend to be more expensive than cap-weighted peers offering similar exposures and could potentially detract from diversification at the portfolio level.
When It Comes to Diversification, Don't Be Naive

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Re: "When It Comes to Diversification, Don't Be Naive"

Post by nisiprius »

There's a huge logical problem with equal-weighting.

If you cap-weight, then the S&P 500 is 80% of the market, which is a very reasonable representation of the market as a whole. In S&P's own delightfully mealy-mouthed, yet accurate statement, "The S&P 500 focuses on the large-cap sector of the market; however, since it includes a significant portion of the total value of the market, it also represents the market." The S&P 500 has had about a 99% correlation with the total market.

However, if 80% of the market isn't enough and you want virtually 100% market coverage, there are many cap-weighted total stock market index funds. Because they are cap-weighted, they hold only small dollar amounts of small-caps and have no practical difficulties or excessive costs in holding them. Nor are they in any danger of breaking the mutual fund diversification rule which prohibits a fund from holding more than 10% of the outstanding stock of any single company. Nor are there issues with transaction costs; the turnover ratio of the Schwab Total Stock Market Index Fund, for example is a tiny 2%.

Cap-weighted: the S&P 500 is darn close to the whole market... but if you want the whole market, it's feasible to get it.

If you decide, for whatever reason, that what you want is equal weighting, you are faced with a dilemma.

It is practical to operate a fund that really does follow an equal-weighted allocation to the S&P 500, one in which each stock constitutes 0.20% of the dollar value of the fund. RSP is such a fund.

Well, sort of.

Run your eye down the "holdings" column, in which every entry should be 0.20%
But, OK. Let's call that "equal enough."

But if you are equal-weighting, then the S&P 500 isn't 80% of the market. It isn't close to representing the market. Total Stock holds 3,630 stocks, let's say the market is about 3,500 stocks.

Equally-weighted, the S&P 500 is about 1/7th of the market. All your holdings are in 1/7th of the market; what sort of "diversification" is that?

Well, you will say... OK, just like adding an extended index fund, I will hold, say, only 20% of my stock allocation in RSP, 500 stocks, and the other 80% in EQWS, the PowerShares Russell 2000 Equal Weight Portfolio. That should give me equal weight in 2,500 stocks which is now getting to be a reasonable representation of the equal-weighted market.

Except that if you actually want equal weighting, EQWS is a joke*. With 2,000 stocks you'd expect each to be held at 0.05% of the dollar value of the portfolio. In reality, some stocks like SpartanNash constitute 0.30% of the portfolio, and hundreds are held at percentages of 0.02% or less.

And even so, it has a 143% turnover ratio.

Now some math on the feasibility of a true equal-weight stock fund. the Vanguard Total Stock Market Index Fund holds $460 billion in assets. If it held each of its 3,630 stocks at equal weight, it would have to be holding over $125 million worth of stock in every company. However, the National Security Group Inc, ticker symbol NSEC, only has a total market cap of 44.25 million. A equal weighted stock market index fund the size of VTSMX would need three times as much National Security Group stock as exists. Thirty times as much as it would be allowed to hold under the diversification rules.

Equal-weighted: the equal-weight S&P 500 is just a small fraction of the equal-weighted market, 1/7th. But if you want anything close to the whole market, equal-weighted, you'll find that it's basically unobtainable.

(*The problem isn't necessarily with the ETF. It tracks misleadingly-named Russell 2000 Equal Weight Index. How that index is defined, I'll leave as an exercise for the reader, except to say it doesn't involve holding each of 2,000 stocks at equal weight).
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Re: "When It Comes to Diversification, Don't Be Naive"

Post by abuss368 »

Thanks Taylor!
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Re: "When It Comes to Diversification, Don't Be Naive"

Post by selters »

Would you even want a total stock market equal weighted fund? Don't you want a cutoff point somewhere? If not, you'd rebalance into all companies that were going bankrupt, all the way down to zero.

I may be mistaken, but most companies in the S&P 500 that have gone bankrupt were taken out of the index before they went out of business.
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Re: "When It Comes to Diversification, Don't Be Naive"

Post by sperry8 »

But as the article points out you do get a small cap premium using equal weight funds. Now one could just as easily combo up VBR along with an S&P equal weight fund to accomplish this (and allow one to toggle/rebalance) but the equal weight fund requires less work. Seems to me a small premium is one of the factors worth having (from research).
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Re: "When It Comes to Diversification, Don't Be Naive"

Post by Alexa9 »

Market weight : large cap fund
Equal weight : small cap fund
I like somewhere in between.
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