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Why You’re Wrong About Diversification Through Index Funds

wrong way sign Diversification is an important concept for investors. Despite the importance of concentration that some prominent investors such as Warren Buffett and Philip Fisher preach, there are also many other equally successful professional investors like John Templeton who make diversification a cornerstone of their investment programme.

Some investors might like to argue over it but in my opinion, there are no right or wrong answers to that and diversification will likely be here to stay.

A common tool for diversification

For many investors, I don’t think I’m too far off the mark in saying that, index funds – funds that track any particular stock market index – are used for diversification purposes to avoid security-specific risks.

But, asset management firm Horizon Kinetics recently showed investors why that’s not necessarily true.

False sense of diversity

In the firm’s 3rd Quarter market commentary, it talked about how exchange-traded funds (ETFs) that track a market index can be a “failed search for security diversification.”

It listed a table, replicated partially below, showing the weights that certain Spanish companies took up in the iShares MSCI Spain Index Fund.

Company Position Weight Cumulative Weight
Banco Santander SA 19.7% 19.7%
Telefonica SA 13.1% 32.8%
Banco Bilbao Vizcaya Argentaria 12.6% 45.5%
Inditex 4.8% 50.3%
Iberdrola 4.5% 54.8%

Source: Horizon Kinetics’ 3rd Quarter Market Commentary

The table above contains the top five shares within the Spanish index fund and together, they accounted for almost 55% of the index’s movement. Any Spanish investor who sought broad diversification through the fund would have ended up owning a concentrated portfolio of shares instead.

It’s the same in our own backyard

This is actually a situation that we see here at home in Singapore too. The most prominent stock market barometer we have is the Straits Times Index (SGX: ^STI) and it is comprised of 30 of the largest publicly-listed companies here.

But, as I’ve mentioned before, almost half of the index is governed by only five shares. The table below shows the weights of the top five shares of the STI as of 30 Sep 2013:

Company Weight in the STI Cumulative Weight
DBS Group Holdings 10.6% 10.6%
Oversea-Chinese Banking Corporation 10.5% 21.1%
SingTel 10.2% 31.3%
United Overseas Bank (SGX: U11) 9% 40.3%
Jardine Matheson Holdings (SGX: J36) 6% 46.3%

Source: FTSE

There are currently two ETFs that track the STI, namely, the SPDR Straits Times Index ETF (SGX: ES3) and the Nikko AM Singapore STI ETF (SGX: G3B). Both ETFs have very low annualised tracking errors of 0.66% and 1.06% respectively. That means to say that the weightings of individual shares within the ETFs are very close to that of the actual index. This results in investors in the ETFs winding up with concentrated portfolios.

This is not meant to discourage investors from the ETFs – that’s hardly the case. Instead, the numbers I’ve presented are just meant to show that an investment into an ETF is not a magic pill for instant diversification.

What can we do?

Of course, the discussion above would naturally raise the question: What can investors do to diversify broadly?

Theoretically, all an investor has to do is to buy a large basket of shares in individual companies, preferably in equal amounts. But as the popular saying by baseball legend Yoggi Berra goes, “In theory, there is no difference between theory and practice – in practice, there is.”

In Singapore, investments in individual shares are governed by the current board lot rules, where only blocks of a 1,000 shares can be traded. This makes diversification particularly onerous for individual investors without deep pockets.

For example, one lot of the airline company Singapore Airlines (SGX: C6L) at its current price of S$10.48 per share will set an investor back by at least S$10,480. Those aren’t trivial sums, especially when there’s a need to diversify among other holdings.

Fortunately, things might change soon. The Singapore Exchange, operator of the Mainboard and Catalist stock-exchanges here, is looking at reducing the standard board lot size of securities listed here from 1,000 to 100 as early as first quarter of next year. The company may even reduce the lot size to 1 eventually after assessing the market.

Should the changes happen, diversification for investors will be a much easier prospect.

But even if these changes fail to materialise, investors could also consider regular shares savings (RSS) plans introduced by the bank OCBC as well as the Share Builders Plan (SBP) offered by brokerage firm Phillips Capital.

The RSS and SBPs are structured in a way to allow individual investors to purchase shares in various blue-chip companies with amounts as little as S$100 a month and can provide an avenue for individual investors to start building a diversified portfolio of individual shares despite not having huge amounts of capital to work with.

Foolish Bottom Line

ETFs offer an almost fuss-free way for investors to take part in the wealth-building capabilities of the stock market by tracking the growth of a market index. That’s true.

But, the notion that they can always provide adequate and broad diversification on its own does not always hold true. We’ve already seen that with the iShares MSCI Spain Index Fund and the STI ETFs.

Bear that in mind the next time you’re looking at diversification through ETFs.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.