How Diverse is your Index Fund?

Thursday, July 23, 2020 8:03 AM | Neal Farmer

Index funds have grown increasingly popular recently for the intrinsic diversification benefits they offer. Diversification is a huge focus for most investors due to the acceptance of Modern Portfolio Theory.

Diversification into uncorrelated investments brings a reduction in overall risk. Additionally, the Efficient Market Hypothesis has led many investors to simply allocate their assets into indices due to the belief that active fund managers cannot outperform the market on a long time horizon.

Simply investing in an index fund such as one that tracks the S&P 500 immediately gets rid of the many of the risks attached to particular companies by having assets spread across a bunch of companies. Thus, investors don’t have to worry about finding, and buying, hundreds of different stocks and can instead simply purchase an ETF that tracks a major index.

In reality though, most of these funds are weighted by market capitalization though, and which means bigger companies having a much bigger impact on the fund than the smaller ones.

For investors the diversity of your portfolio is reduced if your index fund is heavily swayed by how Microsoft (MSFT) or Apple (AAPL) perform. Portfolio managers focused on the diversity and reduction of risk in their portfolio may want to instead invest in an equally weighted fund such as the Invesco S&P 500 Equal Weight ETF (RSP). This kind of fund is equally divided by all 500 stocks meaning that the movement of Gap Inc (GPS) has the same impact as Amazon (AMZN) does.

On the other hand, your SPDR S&P 500 ETF (SPY) fund that is more heavily weighted towards the biggest companies might be a great feature actually. Not many analysts would condemn large investments in Microsoft, Apple, Amazon, and Google. They have, after all, been rising at rates far beyond the rest of the market and that trend doesn't seem to be ending anytime soon.

These massive corporations are already a major staple in people’s lives and their quest for world domination is going quite well so far. Even though a market-cap weighted index fund loses some of the diversification benefits, it makes up for it in higher growth rates as these large companies continue to grow and face little risk due to their sheer size and stability.

Much of the rally since mid March has been led by these huge companies (mostly technology stocks) pulling the indices higher. The S&P 500 is now positive so far in 2020 even though it experienced one of the worst crashes in history earlier this year. However, around 320 of the 500 stocks are currently still in the red so far, meaning that only about 36% of the stocks in the S&P 500 are up this year even as the headline number is also higher. Meanwhile the equally weighted RSP is down roughly 8% on the year.

The major cap-weighted indices all have this apparent lack of diversification. NASDAQ, which is already mostly tech stocks, has performed the best in 2020 and outpaced the S&P 500 and Dow Jones Industrial Average for a long time now. People tracking the NASDAQ with Invesco PowerShares (QQQ) mostly already know they are lacking a lot of the diversity that a broader index.

The SPDR Dow Jones Industrial Average ETF (DIA), while not cap-weighted, offers even less diversity as it only tracks 30 stocks as opposed to the 100 from the QQQ. The Dow only tracks the biggest companies but again this might actually be beneficial for most investors as these companies offer plenty of stability and are critical components of the economy.

While index funds do take a lot of the pain out of diversifying your assets and allowing for easy exposure to the entire market, investors still need to be careful that they know exactly where they are putting their money. Equal-weighted index funds offer a more diversified investment that will help to minimize risk in the event one or more of the larger companies experiences some trouble.

Market capitalization-weighted funds have their place as well and there is likely a reason they tend to be more popular. Many traders may want their assets to be more heavily allocated towards the biggest corporations as they tend to offer some of the best returns with their massive infrastructure and global footprint.

Yes your SPDR S&P ETF may not offer quite the diversification you hoped for, but that may actually be one of its best features.

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