Passive investments vs. diversification

sebtomato

Lots of people just recommend to buy a low cost world tracker fund/EFT, like VWRL from Vanguard, for passive investment (following pretty much the trend of the major stock exchange around the world).

I am all for passive investments rather than active funds, as very few fund managers can actually beat the market. They make their money by charging fees, as opposed to the performance of their funds.

However, I am also very much in favour of good diversification (rule #1 for investment), and VWRL (or similar world trackers) starts becoming on issue in that case:

• 6o% in the USA

• 4% in the UK

• 12% of the ETF is with only 5 companies (due to their current large caps)

  • Apple: still doing well, but too much reliance on one product

  • Microsoft: not really a market leader for quite a few of its products, so market cap may be inflated. The Windows and Office cash cows may really hinder innovation

  • Amazon: doing well, no competition in retail, and leader in cloud

  • Tesla: very inflated market cap, equal to the sum of the next 10 car manufacturers. Increased competition coming and crazy CEO. May deflate quite quickly

  • Alphabet (Google): leader in search/advertisement, but not really succeeding in many other products. The search cash cow may really hinder innovation

Are people comfortable with their investment not being that well diversified? If not, what ETFs/fund do they invest in?

Ideally, I want some very well diversified investment, and having no more than 1% invested in a single company, nor more than 45% in the US.

Nebulous2

I'm very much a newbie to this. We invested £80k, 4 x £20k ISAs 1 each either side of the 20/21 tax year end.  I didn't like the huge emphasis on America and chose some active funds.  Europe, Japan, UK mid-caps.   £20k, £20k, £10k and £10k in index trackers - leaving £20k divided into 6 active funds. Not a single one of the active funds has beaten any of the 4 index trackers. The biggest drag on the whole portfolio has been Jupiter UK mid-cap which is down around 30% and has been further down. 

I sought some advice here before diving in, and discounted it because I wanted to have a try. I've come to the conclusion that I don't know enough, and I'm better sticking to trackers. If you aren't happy with the massive US bias in world trackers you could always reduce that by tracking something more specific - a FTSE 100 tracker for instance. You don't have to go to the higher fees and flawed management risks of the active funds.... 

InvesterJones

That is considered well diversified because it matches the distribution of money in equities worldwide.

You can instead pick flat-weighted funds which don't weight by valuations - you don't gain any more diversification but you instead over-weight less valued assets instead - it's just a different bias.

You can also go for wordwide passive funds that include more smaller companies - FTSE global all cap from vanguard has something like 7000 companies rather than 3700 of the VWRL, though again weights according to market cap to some extent.

Finally you can add diversification yourself by adding a fund which represents the assets you believe are missing for the level of diversification you are looking for - bonds, commodities, property etc. etc. might also help diversify away from equities.

Linton

sebtomato said:

Lots of people just recommend to buy a low cost world tracker fund/EFT, like VWRL from Vanguard, for passive investment (following pretty much the trend of the major stock exchange around the world).

I am all for passive investments rather than active funds, as very few fund managers can actually beat the market. They make their money by charging fees, as opposed to the performance of their funds.

However, I am also very much in favour of good diversification (rule #1 for investment), and VWRL (or similar world trackers) starts becoming on issue in that case:

• 6o% in the USA

• 4% in the UK

• 12% of the ETF is with only 5 companies (due to their current large caps)

  • Apple: still doing well, but too much reliance on one product

  • Microsoft: not really a market leader for quite a few of its products, so market cap may be inflated. The Windows and Office cash cows may really hinder innovation

  • Amazon: doing well, no competition in retail, and leader in cloud

  • Tesla: very inflated market cap, equal to the sum of the next 10 car manufacturers. Increased competition coming and crazy CEO. May deflate quite quickly

  • Alphabet (Google): leader in search/advertisement, but not really succeeding in many other products. The search cash cow may really hinder innovation

Are people comfortable with their investment not being that well diversified? If not, what ETFs/fund do they invest in?

Ideally, I want some very well diversified investment, and having no more than 1% invested in a single company, nor more than 45% in the US.

I agree completely with your concerns and would include other factors where I believe the allocation provided by trackers is not appropriate to my objectives and wishes.  In particular sectors and growth vs value.

The long term 100% equity tranche of my portfolio is based on providing a balance across all factors that I can reasonably control giving for example 40% US, 50% large companies, highest allocation of any company 1.5% for Microsoft etc. My current project  driven by  the events of recent months is to improve control of growth vs value.

When choosing a fund I make detailed use of paid-for Morningstar data to ensure that its allocations work with the overall portfolio.  Past performance is very much a secondary factor.  All my funds are currently active, not for any ideological reason but simply because I have found that niche actives make controlling allocations easier.

One small point - both passive and active funds make their money from charges. Fund managers get no direct benefit or loss from the performance of their funds.

adindas

Wide diversification fits to many people especially those who do not have time to learn new things, to raise up the game. Those who prefer invest and forget strategy. But diversification is not necessary the best investing strategy outthere. 

Acute Traders, people doing DIY investing in individual stocks certainly do not diversify. They will go for the stocks/sectors where the reward is "overwhelmingly" higher than the risk.

Many investing / Trading gurus such as Warren Buffet, Charlie Munger, Peter Lynch, Jim Symons, Howard Mark, etc are against diversification.

Example why diversification might not be a good thing is the inherent part of the market, e.g. the market rotation, sector rotation, bull/bear market etc. In the bear market, recession people turn to value Investing, recession proofs sectors and will avoid investing in high growth stocks especially those with high debts. The opposite in the bull market, the people will target growth companies which expand their business like an octopus generating tons of revenues. During some periods a few sectors are performing better compared to other sectors; The people will rotate their money to better performing sectors. Example in the bear market, recession the sector like Consumer Staples, Grocery Stores, Discount Retailers, Alcoholic Beverage Manufacturing, Death and Funeral Services.sector are normally doing well and the people will rotate their money to those sectors.

Also the recent performance of the bond market. People who blindly believe in diversification of multi assets will keep investing in Bond even they see their return is negative a better alternative out there exist. But some people will pull out from, or stop adding the bond proportion of their portfolio which is performing poorly. They will put it into high interest saving accounts, regular saving accounts temporary which is safer and earning higher yields.

Also just remember there is no strategy that will last forever. People will need to keep adapting their strategy to reflect the environmental condition.

MX5huggy

Or Buffet says S&P 500 index perfectly reasonable investment strategy. (For an American). https://youtu.be/aELZIFfoCf4

ColdIron

MX5huggy said:

Or Buffet says S&P 500 index perfectly reasonable investment strategy. (For an American octogenarian with more money than she could ever possibly spend). https://youtu.be/aELZIFfoCf4

      

AlanP_2

It's impossible to be fully passive and avoid the, reasonable, issues you highlight in some way.

If you want global diversification the most pure passive option would be something like the FTSE Global All Cap as mentioned above.

Once you start tinkering with those allocations you are applying your own active management opinions.

Nothing wrong with that as long as you appreciate what you are doing and why 

Would this be your only investment(s)? 

If not have you looked at your overall situation to identify what your underlying diversification looks like?

We have a mix of accounts, some me are single global trackers and some are more varied with actives and trackers. Looking at them individually is a bit pointless as a high US allocation in one account might be offset by a high UK or EM allocation in others.

JohnWinder

I share your concern about the ‘top heavy’ nature of this index with giant companies and so much of USA , but what to do?
Let’s put aside the folly of trying to choose 5, 10, 50 shares ourself instead of using a fund; we can come back to it if anyone takes too much umbrage.
You could add a global small cap fund (to the large and mid-cap of your example) to increase diversification. History suggests you could get a bit more return, as it’s a bit riskier, but the differences are very small and may not be worth the bother or extra expense of the extra fund. Use portfoliovisualiser to see how it would have changed returns and risk in the past.
Or/and, you could go for some UK home bias with >4% in UK stocks. This reduces your ‘passivity’ by putting a small bet on your home exchange, but Vanguard’s and other analyses (references available if you can’t find them in the bogleheads.org blog) suggest that for many countries a bit of home bias has improved safe withdrawal rates and volatility at the expense of a bit of growth. And it might address a currency hedging issue.
Or, you could go the equal weighting route where you have as much in Apple as you do in Motorpoint the used car people. The performance of large cap funds that equal weight has been not that different from those that cap weight; better in the good times and a bit worse in the bad times. But that hasn’t been the case with small cap. If you cap weight you can logically omit the smallest 15% of the whole market by saying ‘I can’t be bothered with small-cap shares’. But if you think cap weighting is wrong, and equal weighting is right, then you can’t omit to invest in some random 15% of the market - you have to have an equal weight in every share available from the most hopeless looking African miner to Alphabet. Or, if you’re going to deliberately choose the 15% of the market you won’t equal-weight invest in, you’re not a passive investor.
What to do? Plenty, nearly countless fund managers share our concerns and try to improve on cap weighted, well diversified portfolios by using active management. We know how that has turned out, and if you need reminding, start listening at 2 min 40 sec into this interview with a professor of finance (English, no need to worry) in England talking about English fund managers to an English journalist. Basically, 1% of them have sustainably outperformed a comparable index, but they keep the surplus for themselves in higher fees.  https://youtu.be/vxsSC5LIiSA

MX5huggy

ColdIron said:

MX5huggy said:

Or Buffet says S&P 500 index perfectly reasonable investment strategy. (For an American octogenarian with more money than she could ever possibly spend). https://youtu.be/aELZIFfoCf4

      

Not in this video he’s talking about someone starting out with 30 plus years of investing ahead who does not have an edge. 

Millyonare

Almost all stockmarkets around the world are a heap of junk. They suffer from low liquidity (like Italy), strict barriers (like China), aging companies (like Japan), or firms are frantically bailing out (like the UK).

The US delivers extremely high liquidity, very low barriers to trade, constantly refreshed with exciting new companies, and everyone wants to ring the bell in New York. The US has, in effect, become the world's stockmarket. It's the only one that really matters (for now).