Individuals who invest in stocks tend to fall into one of two groups: one group purchases specific stocks, but with little apparent awareness of how effectively they are capturing the performance characteristics of the entire asset class; the second group opts for managed investments that include mutual funds, index funds, exchange-traded funds (ETF) or privately managed accounts. This second group is probably doing a better job than the first at capturing the overall performance characteristics of the asset class, though that depends on the degree to which their total market exposure is properly diversified.
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Is there a a way for an investor to create a concise portfolio that effectively captures the performance characteristics of the entire asset class of U.S. domestic equities? This article will show you a simple way to create a portfolio that will not only capture this performance, but place you in a position to remain endlessly competitive with index funds and actively managed funds.
Establishing Your Benchmark
You must have an established benchmark that you can compare to determine if you are succeeding in effectively capturing the performance characteristics of the asset class. This benchmark must be comprehensive in nature and recognized as being representative of the U.S. equity market. The Standard & Poor's 500 index (S&P 500) consists of large-cap stocks and represents around 75% of the entire market capitalization of the U.S. domestic stock market.
The Standard & Poor's 1000 index consists of small-cap and mid-cap stocks and represents 25% of the aggregate U.S. equity market cap. Standard & Poor's provides a great deal of free information regarding their indices that you can use as guides in structuring your portfolio and comparing performance.
You can structure a portfolio of large-cap stocks that mimics the S&P 500 index. You can structure a portfolio of small-cap and mid-cap stocks that mimics the S&P 1000 index and capture the rest of the overall asset class. You can create a portfolio that blends these two in a roughly 75%/25% weighting and capture the performance characteristics of U.S. domestic equity market, provided you are well diversified among individual securities and within the major sectors of the economy.
Why Not Purchase an Index Fund?
Why not indeed? In 1975, Charles Ellis published an article that he later expanded into a book entitled Winning the Loser's Game. The main point in Mr. Ellis's work is that most professional money managers fail to consistently outperform the market because they are the market. Regardless of asset class, market landscapes today are dominated by highly skilled, highly trained, highly intelligent institutional investment professionals.
John Bogle cites Mr. Ellis's work as one of the major influences in his decision to create index mutual funds when he started The Vanguard Group. Mr. Bogle reasoned that index funds would always be competitive in the long run - an idea that history has proved correct. You can purchase Vanguard's Total Market mutual fund and assure yourself that you will effectively capture the performance characteristics of the U.S. domestic equity market. In addition, you can feel comfortable that you will always be competitive with nearly every other actively managed U.S. equity fund in existence because of ultra-low annual fees, sometimes as low as one tenth of 1% annually.
The advantage to creating your own actively managed, index-like fund is that you can potentially alter it to provide slightly better risk-adjusted returns than the market. Also, you can often manage it in a manner that is even more tax-efficient than an index fund with regard to your own individual tax situation. Finally, if you enjoy the investment process you will find managing your own portfolio to be more rewarding than simply owning an index fund.
Theory and Process
Studies have demonstrated that you can eliminate the vast majority of individual stock risk with as few as 30 stocks if the selection is properly diversified. You can't capture the vast majority of the performance characteristics of an index as large as the S&P 500 by owning only 30 technology stocks; however, you can capture the vast majority of that index's performance if you choose 30 stocks that are representative of the index as a whole.
Standard & Poor's categorizes stocks according to 10 broad sector classifications and a multitude of sub-classifications. From this you can see the market weighting, by percentage, of each sector in the index. You can use this as your guide to proper diversification. For example, assume that you are going to own 30 stocks, with each stock having an initial weighting of approximately 3% of your overall portfolio. If the financial sector comprises 15% of the S&P index, you want to own five stocks from this sector (approximately 15% of your 30 stocks). If the energy sector represents 12% of the index, you want to own four energy stocks, and so on.
Setting up the Portfolio
Ideally, within these selections you do not want to own more than one stock from any one sub-sector. So, for instance, of your five financial-sector holdings you may want one each from savings and loans, banking, insurance, brokerage and investment management. You are, in effect, sampling from the index in accordance with its overall makeup and construction.
Not all sector weightings will be evenly divisible by your 3% average stock weight so you will have to use some discretion as to how many you want to include in each sector class. Sector class weightings will shift over time, but you will find that your weightings will shift accordingly. From time to time you will have to increase or decrease the number of stocks (or shares of stock) you hold in each sector, but that will not happen often.
Another factor to consider is weighted average market capitalization. You can multiply each stock's percentage weight within the portfolio by its market capitalization and then divide by the total number of stocks in your portfolio to calculate the weighted average market capitalization. You can compare against the weighted average market capitalization of the index as published by S&P. You may also wish to calculate your weighted average price-earnings ratio (P/E ratio) and compare that to the index.
The more you do to see that your portfolio mimics the index, the closer your performance will be to that index. In fact, you may want to limit your holdings to names that are actually in the index. These names are also available from S&P and consist of companies investors see and hear about every day of their lives.
Picking the Stocks
If the studies are correct, by following the process above you have put yourself in a position to capture over 90% of the index's performance over time, regardless of what individual stocks you select. The process and structure largely protects you from losing too much as the result of poor individual stock selection. Still, this is an area where you can add incremental risk-adjusted value - also known as the alpha - over time. This article will not delve into individual stock selection, but there are many valid approaches available to you and many great places to start your research. It should be noted that as more stocks are added to your portfolio, there is further diversification that can be achieved, but this comes at the cost of lower volatility (i.e., chance for greater returns).
You will find this approach timelessly competitive, not only with the market index but with virtually all the actively managed funds of Wall Street professionals. It is simple, easy to construct and cost effective, as turnover can be held to a minimum. Depending on your individual trade costs, however, it may not make sense to create your own U.S. equity market "mutual fund" unless you have about $100,000 to invest, as index funds and ETFs have internal fees that only average .010 to .015%. If you do have enough funds to work with, though, this process will allow you to easily become your own equity portfolio manager.