We’re not as diversified as we think

Don’t get caught in the market-cap trap.



Online only.


Read an interesting article by the Financial Post’s Jonathan Chevreau this morning saying we don’t really know what diversity means. According to Yves Choueifaty, a Paris-based mathematician and money manager, who spoke with Chevreau, ETFs are largely market-cap weighted so big name stocks are overrepresented in the indexes.

“That introduces a ‘size bias’ that increasingly overweights sectors that are already overvalued and getting more so,” writes Chevreau. “That occurred in 1999-2000, when TMT — telecom, media and technology — stocks inflated, drawing in investors at the worst possible time, then burst.”

One way to get better diversification is through fundamental indexing, says the writer. Picking stocks by earnings and revenue, rather than market-cap, would result in more variety. Equal weighting also works. “An equal-weighted portfolio with 100 stocks would each have a 1% weight no matter how large or small the company was,” says Chevreau.

My favourite option (at least it would be the most fun) is “throwing darts at the stock pages.” If you randomly choose enough of equities, market-cap won’t factor into the equation.

Choueifaty’s prefered investing method is to find stocks that do not correlate with each other. “Thus, his U.S. portfolio holds maybe 60 stocks — versus 600 for the MSCI US benchmark — but he insists those 60 stocks are more diversified than the 600. The resulting portfolio is 1.5 times as diversified as the index and less volatile.”

You can read the rest of the Financial Post story here.

37 comments on “We’re not as diversified as we think

  1. The argument for fundamental weighting is not new, and it is compelling, although it is considerably more expensive than cap-weighting. Claymore's fundamentally weighted ETFs have performed very well since they appeared, especially its Canadian equity fund (CRQ). I'm not convinced that it will outperform cap weighting over the very long term, but I wouldn't argue the point very hard.

    However, an equal weighted broad-based index doesn't make sense as an investment strategy: its arbitrary, not to mention extremely hard to track without constant rebalancing. There are equal-weighted ETFs that track the S&P 500, but how does it make sense to hold the same amount of Exxon Mobil and Eastman Kodak, when the former company is 172 times larger? Saying that cap weighting has a "size bias" is like saying it's not fair that Ontario has more seats in Parliament than Prince Edward Island.


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