- Every now, and then I hear the comment
that index funds result in over diversification.
The thinking goes
that instead of buying all of the companies in an index,
you might be able to focus on a smaller subset
that you believe will perform better
than the market as a whole.
It makes sense.
Of course you can't beat the market by holding it.
The problem is that decreasing diversification
leads to a wider range of possible outcomes,
with a disproportionately large probability
of a negative outcome, relative to the market.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of Common Sense Investing
I'm going to tell you why index funds
do not lead to over diversification.
(techno music)
Before I get into the episode,
I wanted to take a moment
to thank all of you for watching and subscribing.
I didn't really know what to expect
when I started making these videos two years ago,
but the response has been excellent
and it feels like there's a great community building
around the channel.
To talk about over diversification,
I need to introduce something called dispersion.
It is the size of the range of returns observed
for an investment strategy.
If an investment strategy has high dispersion,
we would expect the actual result realized by an investor
over a given period of time
to fall in a wider range of possible outcomes
above and below the expected value.
Another way of thinking about high dispersion
is that your outcome is less reliable.
Even if you have good reason to expect
some amount of average long-term return,
high dispersion means
that you are less likely to get it.
On the other hand, a low dispersion of outcomes
means that your actual result is more likely to be close
to what you expected or more reliable.
Now, to be clear if your goal is to knock it out of the park
and make massive gains by picking stocks,
then you want high dispersion.
This doesn't mean
that you're going to get your desired result,
but to have the potential for massive gains,
you also have to accept the potential for massive losses.
That is what you get with higher dispersion.
For any longterm investor
who's hoping to meet their financial goals
as opposed to trying to knock it out of the park,
a low dispersion of outcomes is much more favorable.
The relationship between the dispersion of returns
and diversification is important.
In 2006, an academic definition called active share
was introduced to examine the concept
of intentionally under diversifying
relative to an index in an attempt to add value.
This is how traditional active management works.
Active share measures the extent
of active management being used by a fund manager.
Stated differently active share measures
how different an investment strategy is from the index.
When someone says
that index funds lead to over diversification,
they're effectively saying that you should invest
in something less diversified with higher active share
in order to do better than the index.
In 2012 paper, Vanguard looked at the dispersion of outcomes
for actively managed mutual funds,
alongside their level of active share.
They found that as active share increases,
the dispersion of outcomes also increases.
This is exactly what you would expect.
When you hold a subset of the index,
you're going to get a result better or worse than the index.
And the more concentrated the strategy is,
the wider that possible range of outcomes will be.
A 2018 paper from dimensional fund advisors
took a different approach
to assessing the importance of diversification.
I'm going to pick on dividend investors for a moment here.
If you remember my video on dividend growth investing,
I explained that dividend growth stocks on average
have market beating performance
which is mostly explained by their exposure
to the value and profitability factors.
Factors are risk-based premiums
that explain differences in returns between securities.
For example, value stocks on average,
have higher expected returns then growth stocks.
Stocks with a robust profitability
have higher expected returns
than stocks with weak profitability.
Exposure to these factors is what explains
the strong past performance of dividend growth stocks,
not the magical dividend fairy.
This is important because cause factor exposure
can be attained with a diversified portfolio
that includes both dividend paying and non-paying stocks,
as opposed to individually selected dividend payment stocks.
The importance of this
will become even more clear in a moment.
The dimensional point paper that I mentioned
took an index of 2,637 global large cap stocks
with an emphasis on the size,
value and profitability premiums.
In other words, it is a global large cap index,
that has been adjusted to have more weight
in the smaller large stocks, large value stocks,
and large profitable stocks relative to the market.
They tested it against the MSCI all country world index
from 1994 through 2017.
They found that the adjusted index beat the market index
by an annualized 0.8%.
To test the effect of diversification
on the reliability of this outcome,
they sampled portfolios with 50 stocks,
200 stocks, 500 stocks, and 1000 stocks
selected from within the adjusted market index.
Each of these sub portfolios was constructed
to have the same average excess return as
and similar volatility to
the adjusted market index full form.
Phrased differently,
the subject portfolios will look the same
as the overall adjusted index
from the perspective of expected returns and volatility
with the main difference being
their level of diversification.
Despite the sub portfolios being constructed
to have the same excess return and volatility,
the dispersion of their returns increased
with each reduction
in the number of securities in the portfolio.
Due to the increase in dispersion,
the authors found
that while the probability
of the full adjusted index beating the MSCI
all country world index over five years was 92%.
The clone portfolio made with only 50 stocks
had a much lower 63% probability
of beating the market index over five years.
This should make clear
that my example of a dividend investor,
hoping to capture the value and profitability premiums,
which are what explain
the excess returns of dividend stocks,
while holding only 20 or 30 stocks
is in for a wide dispersion of potential outcomes.
They may do really well,
as I know some dividend investors have,
but they may do really poorly.
There's no a way to predict the actual outcome
that any individual
with a concentrated portfolio will get.
Dimensional ran this analysis
in the context of their investment products,
which own the market as a whole,
while targeting stocks with higher expected returns.
But they're finding extends
to a traditional index fund as well.
Capturing the market premium similarly requires
broad diversification,
where more diversification
increases the reliability of the outcome.
To me, this finding is both intuitive and profound.
We know that it tends to be a small number of stocks
that drive most of the market's returns.
So without the ability to predict the future,
of course you need to hold all the stocks
to get an outcome similar to the market.
It also tells us very clearly,
that if a reliable outcome is the goal,
there is no such thing as over diversification.
I mentioned that we know
that a small subset of stocks
drive most of the market's returns,
in his 2017 paper Hendrik Bessembinder found
that 58% of common stocks in the U.S.
have underperformed the T-BILL rate
over their full lifetime.
And the entire gain in the us stock market since 1926
is attributable to only 4% of the stocks.
In their 2015 paper, Heaton, Polson and Witte
constructed a simple model to illustrate why this matters.
Let's say we have an index consisting of five securities,
four of which will return 10%,
and one of which will return 50% over a given time period.
Active managers will create portfolios
using an equally weighted subset
of one or two of the available securities.
Based on this,
there will be a set of 15 possible
actively managed portfolios.
10 of the 15 portfolios will earn a 10% return,
due to omitting the 50% stock,
and five of the 15 portfolios will earn either a 30% return
or a 50% return due to holding the 50% stock
depending on whether it is a one or two security portfolio.
In this example, the mean average return
of all active fund managers will be 18%.
While, the median return
for the active managers will be 10%.
Two thirds of the actively managed portfolios
will underperform the index
due to their omitting the 50% returning security,
which is always included in the index.
The index portfolio containing all
of the stocks will return 18%.
The surest way to avoid the relatively likely bad outcome
of the active managers
is holding all of the stocks in the index.
We know from the research on active share
that less diversification relative to an index
results in a wider dispersion of outcomes around that index.
It is absolutely true
that less offers the chance at a better outcome,
but it also offers the chance at a worse outcome.
We also know that capturing the risk premiums
that stocks deliver over time becomes less likely
as we decrease the number of holdings in a portfolio.
Finally, the concentration of stock returns
in a relatively small number of stocks means
that there is a disproportionate risk
of trailing the market, as opposed to beating it
by intentionally reducing diversification.
If your goal is a reliable outcome,
which seems like a sensible goal for any long-term investor,
I do not think that index funds are over diversified.
Has anyone ever told you
that index funds are too diversified?
Tell me how you responded in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone
who you think could benefit from the information.
Don't forget, if you've run out
of Common Sense Investing videos to watch,
you can tune in to weekly episodes
of the Rational Reminder podcast
wherever you get your podcasts.
(upbeat music)