Be Careful – You Might Have All Your Eggs in One Basket Unknowingly

A friend of mine had recently asked me a question related to how his assets should be diversified. Although his question has nothing to do with what I’m going to discuss about shortly, it did bring to my mind said topic.

When it comes to diversification in the share market in Singapore, it’s easy to point out index-trackers as an easy means to achieve diversification. After all, Singapore’s share market benchmark, the Straits Times Index (SGX: ^STI), consists of 30 different shares which are incidentally some of the shares with the largest market capitalisations here.

An owner of an index tracker that aims to mimic the Straits Times Index – there are currently two exchange-traded funds that serve this function in Singapore and they are namely the SPDR Straits Times Index ETF (SGX: ES3) and Nikko AM Singapore Straits Times Index ETF (SGX: G3B) – would thus wind up with ownership of the 30 different shares that make up Singapore’s market benchmark.

But, here’s an important thing to consider: The Straits Times Index may not be as diversified despite holding 30 different names. As of 31 May 2014, based on data from Morningstar for the SPDR Straits Times Index ETF (such data could be used as a close proxy for what’s happening with the Straits Times Index itself), 31.5% of the ETF is made up of companies that belong to the financial services sector.

Compared to the global average where financial services companies make up roughly 17% of a typical fund, it’s easy to see how the Straits Times Index is actually not as diversified as one might think.

Now, this can be dangerous if an investor owns say, huge blocks of shares of DBS Group Holdings (SGX: D05) and Oversea-Chinese Banking Corporation (SGX: O39) and wants to diversify his share market exposure using the Straits Times Index ETFs. That wouldn’t be diversification at all, given that DBS, OCBC and United Overseas Bank are the three financial services outfits (the trio are banks) that take up a huge chunk of the index.

An investor, who ends up doing so, would have unknowingly placed most of his or her eggs in one basket and be left dangerously exposed to the ebb and flow of Singapore’s banking sector.

At this juncture, it’s perhaps fair to point out that this isn’t meant to be a criticism of the investment merits of index trackers – the point here is to merely highlight an important area to look at regarding diversification (the concentration of holdings in particular sectors) that investors might have overlooked.

Now, one important question might come to mind: How then should an investor invest in the share market to be adequately diversified? It’s easy theoretically – you can purchase shares of individual companies from different sectors.

But as the baseball legend Yoggi Berra once said, “In theory there is no difference between theory and practice. In practice there is.” In Singapore, there are lot size restrictions where investors can only buy and sell shares in lots (one lot is made up of 1,000 shares) for most counters. This makes building a portfolio particularly onerous, especially for those starting out with relatively small sums of capital.

Thankfully, things may change for the better in Singapore, when lot sizes could be cut to something more sensible”, my colleague David Kuo wrote a few months back. He also wrote that “That day cannot come soon enough for me” and I fully agree. I too, can’t wait for such a change to occur.

This brings me back to the index trackers. Our investing actions are grounded in the real world and we have to adapt and sometimes make do with whatever is available. Although the index trackers we have for the local share market might not be ideal in terms of providing adequate diversification in certain aspects, they might still be the easiest way for many investors to spread their risks in the share market given the current situation.

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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 writer Chong Ser Jing doesn’t own shares in any companies mentioned.