The Dangers of “Diversification”

Most investors feel that they can’t beat the returns of the market by picking their own stocks. History has shown us, and index fund marketing reiterates this all the time, that active managers’ returns trail that of the overall market. And, if the experts can’t beat the market, why should you try?

As a result, investors have taken to passive investing in index funds. These funds mimic the returns of the index upon which they are based and offer investors diversification across the member stocks of that index. Thus, by investing in an index fund or ETF, investors receive similar performance to the index and have a diversified portfolio.

I’m not about to tell you that diversification is bad, or owning a larger number of stocks is a silly idea. Frankly, I am a strong believer in a diversified portfolio. History has told me, repeatedly and often with a sledgehammer, that not every stock I buy is going to go higher.

This is reality and, to protect myself from the dangers of any possible error in stock selection, I have diversified my portfolio. I put at the most 10% of my portfolio in one stock and, if that stock appreciates to 20% of the portfolio, I sell half immediately.

As an example, diversification has saved me from having all my money in Aqua Metals. This is a company I love and feel is going higher. Yet, it hasn’t lately and, by diversifying, I had a nice position in Cryoport. Which did so well, that I was forced to trim it after it tripled. So, you see, diversification has made me money this year.

What I will say, however, is that most investors’ belief’s that they can’t beat the market and that buying an index represents diversification are about to be put to the test. This is because, like everything else in life, the returns of active managers versus indexes is a very cyclical thing and we are reaching a stage where one can expect money managers to put up good numbers; meanwhile, the indexes themselves just might become a bad investment for a while as well.

Since 2009, the amount of money flowing into passive (i.e. index funds and ETFs) investments as opposed to active managers has been very dramatic. This has accelerated recently with negative asset flows having reached the heretofore unassailable hedge funds, which are losing assets at a previously unheard of pace.

As with any investment, when money chases an asset class it outperforms. This has happened in the passive versus active managers as one would expect. The more money that goes into index funds, the more the indexes go up. I foretold this year’s asset shift and outperformance last December with this story.

The counterbalance of money flowing into passive funds is the outflow from active managers. These investors tend to have a more eclectic mix of stocks and, when they lose assets, they are forced to sell these shares. The new money is buying indexes and their component stocks, however, so, if the active manager is selling a non-index stock, it will go down while the index stocks go up. Thus, the active managers underperform the indexers during this period of asset reallocation, which is just what we have seen.

As the above chart shows, we have had an extended period of outperformance by the passive managers. The result of this, in my opinion, is a major disconnect in the market where the fund flows into the largest components of the indexes has warped their valuation compared to the rest of the market. And, it has created a situation where something generally considered diversified is actually not at all.

If you look at the S&P 500 index, you’d think it’s a well diversified pool of assets from an investment standpoint. However, if you start realizing that more and more of the ownership of those stocks is index funds, and, that index funds have been the hottest investment vehicle for buying stocks for several years, the conclusion is inevitable that the whole index is at risk from a reversion to the mean in which assets would flow out of index funds.

Instead of being diversified by owning a fund with 500 individual stocks, investors are concentrated in an asset class (the S&P index) that is likely to trade as a single entity. It’s like feeling diversified by owning several pieces of real estate…but, if they are in the same neighborhood and that neighborhood suffers from a large fire, you’ll find out quickly that you’ve got all your eggs in one basket and they just got fried. As Barron’s asks, is it time to return to active managers as a risk management strategy?

This scenario is even more dramatic in the QQQ, which is the NASDAQ 100 Index ETF. In here you have five of the most successful companies (Google, Apple, Amazon Microsoft and Facebook) of the last decade, along with 95 other companies. These companies have done very well and are broadly owned. The index has done well and is also broadly owned. As a result, their valuations have gone up and, thus, their representation in the index has as well.

The top five largest companies in the QQQ represent over 40% of the index. This is NOT a diversified pool of assets. It’s actually highly concentrated in these names.

These five companies are all great companies. But, they can, and will, have times where the share prices decline. This is inevitable. Now, however, when you throw in the amount of index money chasing them and the concentration in portfolios, you are looking at a lot of risk for someone that thought they were “diversified”. When the tide shifts, as it always does, investors in these companies will suffer greater than the market.

For a good piece on how the top 10% largest companies by market cap have historically underperformed the broad market, read this piece by Forbes.

For those who know me, you understand that I believe in the cyclicality of markets. As such, I’m a firm believer that active management will have its day in the sun again, and soon. On a small scale example, the Tailwinds Select Portfolio is up over 25% since inception and I’m feeling like our outperformance is just getting started.

Throughout history, investment returns have always returned to the mean. Investors need to be aware of this and understand the risks they assume when they invest. My concern is that we will see a return to the mean in the returns of the major indexes, while other companies’ shares will outperform. And, when this happens, ETF and index investors will take it on the chin as a result of holding their “diversified” portfolios.

 

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