Author Topic: How are you diversifying against sector concentration in index funds?  (Read 1428 times)

NorCal

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I personally keep a big chunk of money in SCHB, which is a "whole market" fund that theoretically invests across the entire universe of domestic stocks. 

Except when I look at the holdings, I see Apple, Microsoft, Amazon, Facebook, Tesla and Alphabet taking up nearly 20% of my entire investment.  This problem is even worse in your S&P 500 funds, where these stocks are more concentrated.

I just don't feel these funds are diversified they way they should be when 5.5% of my investment is in Apple, and only 2.3% is in Energy and 2.4% is in Basic Materials. (As a side note, part of my educational background included doing the math on constructing different types of indexes, so I am familiar with why the indexes look like this)

I do keep some money in SCHA (a small cap fund), which is better.  But it still has Health Care and Tech over-weighted compared to some of the more mundane sectors.   

Does this concentration concern anyone else?  If so, have you done anything to mitigate it?

I am considering adding a few individual stocks or sector focused funds in these underweight sectors just to balance things out a bit.  I haven't made a decision on what this would look like yet.

cool7hand

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Re: How are you diversifying against sector concentration in index funds?
« Reply #1 on: February 17, 2021, 07:40:11 AM »
Posting to follow because of our use of SCHB. Was not concerned, but keeping an open mind to what others say.

RWD

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Re: How are you diversifying against sector concentration in index funds?
« Reply #2 on: February 17, 2021, 08:15:34 AM »
Have you considered investing in international index funds?

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #3 on: February 17, 2021, 10:24:15 AM »
Have you considered investing in international index funds?

I do invest in international index funds.  My portfolio is 50% domestic stocks, 20% international stocks, 20% bonds, and 10% alternatives.

When I dig into the details, the international index funds suffer from the same concentration problems as any other market-cap weighted product.  I figured that I'd focus on the domestic stocks, as that's what most people here can relate to, and it seems to be where the concentration is worst.

shinn497

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Re: How are you diversifying against sector concentration in index funds?
« Reply #4 on: February 17, 2021, 10:29:43 AM »
Value

MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #5 on: February 17, 2021, 10:51:04 AM »
A value tilt is a conventional answer, but value has lagged the broader market for some time owing to those tech stock returns.  It might be hard to stick with that allocation.

Based on asset class correlations, REITs might offer better diversification than international or even emerging markets.  The S&P 500 and international stocks have been 0.90 correlated over the past 12 years, while REITs have a 0.73 correlation over the same time period.  Just make sure they go in tax-advantaged accounts, as the income they produce is very tax inefficient.
https://www.portfoliovisualizer.com/asset-class-correlations

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #6 on: February 17, 2021, 11:18:37 AM »
A value tilt is a conventional answer, but value has lagged the broader market for some time owing to those tech stock returns.  It might be hard to stick with that allocation.

Based on asset class correlations, REITs might offer better diversification than international or even emerging markets.  The S&P 500 and international stocks have been 0.90 correlated over the past 12 years, while REITs have a 0.73 correlation over the same time period.  Just make sure they go in tax-advantaged accounts, as the income they produce is very tax inefficient.
https://www.portfoliovisualizer.com/asset-class-correlations

Yea, that's along the lines of what I was thinking. 

Honestly, I think you can backtest any strategy over the last ten years and its level of variance to the index will be based almost entirely on how the big tech names were weighted in the portfolio.  I'm skeptical this will continue for another decade, but we will only know when this has changed with the benefit of hindsight.

My "Alternatives" portfolio includes a portion of REIT's (Domestic & International), MLP's and a small allocation to Gold.  I'll probably look at this a bit deeper and see if it makes sense to switch to some smaller cap REIT names (valuations are significantly better there) and maybe replace Gold with some mining companies.


MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #7 on: February 17, 2021, 12:02:43 PM »
If you plug VGSLX (Real Estate) and VTSAX (U.S. Market) into portfolio visualizer, you get a 0.69 correlation over the past ~20 years.  You may or may not want to exclude the 2008 crisis that hit real estate hardest.
https://www.portfoliovisualizer.com/asset-correlations

You could read David Swensen's book "Unconventional Success".  Swensen ran Yale's Endowment very successfully for years, causing other colleges to imitate his approach.  I believe he popularized the idea of a 20% tilt to REITs, and his book could provide a better argument for it than asset correlations.
https://www.amazon.com/dp/B003YCOR9Q/

Telecaster

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Re: How are you diversifying against sector concentration in index funds?
« Reply #8 on: February 17, 2021, 12:45:13 PM »
You hit the problem square on the head.  Most index funds are cap weighted so even though you are buying the extended market, you are still mostly investing in large caps.

One solution is to buy three ETFs say, 60% large cap (S&P 500 index) 30% mid-cap, and 10% small cap.  I'll have to double check the percentages, but that should get you pretty close to equal weight.

Or you could buy an equal weight ETF like RSP, which is equal weight S&p 500.  QQQE is the Nasdaq equal weight ETF.

shinn497

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Re: How are you diversifying against sector concentration in index funds?
« Reply #9 on: February 17, 2021, 03:15:08 PM »
If people are doubting value. Then it is the exact reason to stay in value. Long periods like this are completely to be expected. You can't base investing behaviour on recent trends, even 10 year ones. You must do so with robust evidence. and there is just as much robust evidence that the factors aid in diversification as there is for the market itself to continue to produce returns.

Shane

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Re: How are you diversifying against sector concentration in index funds?
« Reply #10 on: February 17, 2021, 04:02:46 PM »
OP, you might like Personal Capital's investment strategy. PC seems to be making an attempt to overcome the 'limitations' of index funds you bring up. Personally, I'm quite content owning shares of companies based on their market capitalization. The fact that Big Tech is heavily weighted in VTI and SCHB, right now, seems like a complete non problem to me.

Telecaster

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Re: How are you diversifying against sector concentration in index funds?
« Reply #11 on: February 17, 2021, 04:35:02 PM »
OP, you might like Personal Capital's investment strategy. PC seems to be making an attempt to overcome the 'limitations' of index funds you bring up. Personally, I'm quite content owning shares of companies based on their market capitalization. The fact that Big Tech is heavily weighted in VTI and SCHB, right now, seems like a complete non problem to me.

^ Excellent point.  We won't really know the best way to invest right now until long in the future.  Good old fashioned cap-weight index might be the way to. 


NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #12 on: February 17, 2021, 05:16:08 PM »
OP, you might like Personal Capital's investment strategy. PC seems to be making an attempt to overcome the 'limitations' of index funds you bring up. Personally, I'm quite content owning shares of companies based on their market capitalization. The fact that Big Tech is heavily weighted in VTI and SCHB, right now, seems like a complete non problem to me.

I really do like the Personal Capital approach.  It's conceptually sounds and well thought through.  I just don't want to pay 50bps+ for it.  I conceptually like the idea of equal weight funds, except that they are pretty tax inefficient (always selling the gainers).

I'm considering building something similar, but with a DIY approach.  I'm still thinking through the exact mechanics, but it would essentially be an index I create, with roughly equal weight to sectors and large/mid/small cap stocks.  Since I'm still in the accumulation phase, I would largely handle rebalancing through my buying activity to avoid capital gains tax.  I'd continually be buying whichever sector is under-performing.

A minor wrinkle is that I don't want to sell my existing funds, as that would create a pretty large capital gains hit.  I'd be starting this with all new funds. 

On a semi-related note, I'm going stir crazy as a SAHD during pandemic.  This is the type of thing I take on to give myself intellectual stimulation.  Maybe I just need to go back to work....

hodedofome

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Re: How are you diversifying against sector concentration in index funds?
« Reply #13 on: February 17, 2021, 10:40:55 PM »
Tech continues to take over more and more of our lives, and the nature of the internet is that it benefits a few companies at the expense of many smaller companies. The bigger a social network, the more useful it is. So Facebook takes over everything. The more people use Google, the better it gets, which makes it head and shoulders better than everyone else and it becomes a positive feedback loop. The bigger Amazon gets, the more everyone wants to sell their product on Amazon, making it more useful for both consumers and sellers, another positive feedback loop.

The internet has network effects which will make a few companies absolute giants, and all commerce will go through them. This isnít changing anytime in the near future, and these tech companies will continue to grow. No other company in history could be this big and still growing 30-40% per year.

No other company in history could do this, because they didnít have the internet. The internet created this scenario and these companies and almost all of our lives will be spent on the internet.

You better have these companies taking up your portfolio, cause there isnít going to be much growth in other industries that will be obsolete. Value has sucked because there are so many value traps these days. Companies that will eventually go out of business because tech is replacing them at a freight train pace.

Just wake up every day and picture the future like Wall-E. Who benefits in that scenario? Who is obsolete? Stick with the companies that will be around in that future, and leave the companies that have no place in that future to the cigar butt value guys. Unless youíre a pretty good cigar butt value guy.
« Last Edit: February 17, 2021, 10:44:45 PM by hodedofome »

MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #14 on: February 18, 2021, 02:56:40 AM »
Most of my portfolio probably doesn't have lessons for others, and it can't be replicated now anyways.  I invested in stocks beaten up during March 2020, counting on a recovery to provide more gains than bankruptcies.  That has proved stunningly correct, but I've already started selling some, so it's a bit late to imitate my approach.

Although my "main" index funds are now a fraction of my portfolio, that seems like the most relevant part for other people.  I opted for a 50/50 split between US and international, wanting to preserve assets rather than grow as fast as possible.  I have about 1/3rd U.S. total stock market, 1/3rd total international, and 1/3rd in tilts.  I hold a tilt to emerging markets (1/6th) and to a momentum ETF (1/6th).  The emerging markets has lower correlations to U.S. stocks than international overall.

One problem with value tilts is how long it takes to play out.  Ten years is too long for me, which is what motivated me to switch from small cap/value to momentum.  I took advantage of a small/value ETF that was hit hard last year, and am profiting off it's recovery.  But it's a very small allocation that I plan to sell this year.

habanero

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Re: How are you diversifying against sector concentration in index funds?
« Reply #15 on: February 18, 2021, 03:18:32 AM »
I have global index funds, but even in those the US mega-techs make up a pretty good chunk.

In the MSCI All-country world index  as of end Jan AAPL was 3,83%, MSFT 2,83%, AMZN 2,32%,Alphabet A and B1,83,FB 1,02%, TSLA 1,01%. This index has 2962 constituents and covers approximately 85% of the investable universe (measured in market cap, I assume). It covers 50 countries - 23 developed markets and 27 emerging markets. Tech is 22% of the index. Think Amazon is under "consumer discretionary" and not tech btw.

I also hold some domestic regional banks as single-names. They are pretty boring but pay good dividends and the after-tax returns is massively better than having money in a savings account. They can of course tank for a variety of reasons, but risk/reward is pretty good in my opinion.
« Last Edit: February 18, 2021, 07:50:39 AM by habanero »

cool7hand

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Re: How are you diversifying against sector concentration in index funds?
« Reply #16 on: February 18, 2021, 07:23:29 AM »
+1 on refusing to pay 50+ basis points for PC or any other model.

marty998

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Re: How are you diversifying against sector concentration in index funds?
« Reply #17 on: February 18, 2021, 12:29:51 PM »
FB is doing a pretty good job of getting Australians to turn off its platform these days.

Iím only really on there for one reason (to keep up to date with my fun run events). Iím sure one day those events will find a new way to build an online community sans the evil big tech bastards.

Itís wrong to say their success is guaranteed. History is littered with the arrogant too-big-to-fails doing exactly that.

Hubris is the biggest killer, and thereís been a lot of it thrown around lately by all of Big Tech.

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #18 on: February 18, 2021, 01:41:42 PM »
FB is doing a pretty good job of getting Australians to turn off its platform these days.

Iím only really on there for one reason (to keep up to date with my fun run events). Iím sure one day those events will find a new way to build an online community sans the evil big tech bastards.

Itís wrong to say their success is guaranteed. History is littered with the arrogant too-big-to-fails doing exactly that.

Hubris is the biggest killer, and thereís been a lot of it thrown around lately by all of Big Tech.

Well said. I think the big tech companies have created some great businesses that have opportunities for growth over the coming years. But like you said, there are risks.  The real question is what price is being paid for the shares.  Iím happy these companies are part of my portfolio.  I just donít want them to be 25% of my portfolio.

The argument that theyíll be a bigger part of our lives in the future comes from such a fundamental misunderstanding of how investing works. And I keep hearing that from more and more people. The exact same arguments were made for investing in Cisco and Qualcomm in the late 90ís.

ChpBstrd

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Re: How are you diversifying against sector concentration in index funds?
« Reply #19 on: February 18, 2021, 01:51:55 PM »
FB is doing a pretty good job of getting Australians to turn off its platform these days.

Iím only really on there for one reason (to keep up to date with my fun run events). Iím sure one day those events will find a new way to build an online community sans the evil big tech bastards.

Itís wrong to say their success is guaranteed. History is littered with the arrogant too-big-to-fails doing exactly that.

Hubris is the biggest killer, and thereís been a lot of it thrown around lately by all of Big Tech.

If the Aussies can run off Facebook, I might buy EWA. Imagine the economic impact of all those people spending their time actually doing things instead of staring at phones. Imagine their advantages as the US and other countries are destabilized by the misinformation economy. Imagine all those advertising dollars staying in their local economy rather than flowing to the US.

The future is a highly regulated closed internet. The question is how many democracies will collapse until we get there.

MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #20 on: February 19, 2021, 03:41:15 AM »
If U.S. Congress was internet savvy, they might have blocked Facebook from acquiring a competitor like Instagram.  But there doesn't seem to be an appetite for anti-trust actions yet, so Facebook can both benefit from network effects and buying up it's competition.  That combination is hard to beat.


If the Aussies can run off Facebook, I might buy EWA. Imagine the economic impact of all those people spending their time actually doing things instead of staring at phones.
I think Facebook is going to stay in Australia, and just drop news feeds.  But I checked on Portfolio Visualizer, and Australia is only 0.79 correlated with the U.S. stock market, so it might help diversification.

Not that I recommend it, but I noticed Latin America is only 0.69 correlated with U.S. stocks, so many months ago I bought a leveraged ETF that tracks Latin America.  Call options are too expensive for both that leveraged ETF, and the unleveraged ETF it tracks... so I wound up buying call options for Mexico and Brazil, which together are 80% of Latin American stock markets.  It's very risky, but that risk hopefully occurs at slightly different times than risks in the U.S. market.

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #21 on: February 19, 2021, 07:02:49 AM »
Not that I recommend it, but I noticed Latin America is only 0.69 correlated with U.S. stocks, so many months ago I bought a leveraged ETF that tracks Latin America.  Call options are too expensive for both that leveraged ETF, and the unleveraged ETF it tracks... so I wound up buying call options for Mexico and Brazil, which together are 80% of Latin American stock markets.  It's very risky, but that risk hopefully occurs at slightly different times than risks in the U.S. market.

Be careful with those leveraged ETF's.  They are not designed to be held for long periods of time.  I studied these a bit about a decade back.  My memory is a little fuzzy, but I believe they are based on underlying futures contracts.  These naturally decay in value over time.  I recall a study of them that guaranteed if you held both the leveraged long and leveraged short ETF of the same index, you were guaranteed to lose something like 3-5% per year.  It was a pretty bad deal.

I do like the idea of holding a non-levered ETF in international regions that are under-represented in the bigger indexes.

MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #22 on: February 20, 2021, 07:35:26 AM »
Not that I recommend it, but I noticed Latin America is only 0.69 correlated with U.S. stocks, so many months ago I bought a leveraged ETF that tracks Latin America.
Be careful with those leveraged ETF's.  They are not designed to be held for long periods of time.  I studied these a bit about a decade back.  My memory is a little fuzzy, but I believe they are based on underlying futures contracts.  These naturally decay in value over time.  I recall a study of them that guaranteed if you held both the leveraged long and leveraged short ETF of the same index, you were guaranteed to lose something like 3-5% per year.  It was a pretty bad deal.

I do like the idea of holding a non-levered ETF in international regions that are under-represented in the bigger indexes.
I delayed replying so I could look at some academic papers, but all of the ones I read mentioned theoretical models.  They aren't modeling actual maneuvers of real leveraged ETFs.  They assume fixed leverage, for example.  Here's some data from UPRO and SPY that questions fixed leverage:

2019 Apr -> now :  UPRO 63.6% vs SPY 34.8%
(UPRO seems to have 1.8x leverage instead of 3x leverage)
2019 Dec -> 2020 Apr :  UPRO -52.2% vs SPY -14.6%
(This covers the start of the pandemic, where UPRO lost at 3.6x leverage)
2020 Apr -> 2020 Dec :  UPRO 133.9% vs SPY 37.4%
(Again 3.6x leverage, but on the upside)
2020 Aug -> 2021 Feb :  UPRO 38.9% vs SPY 13.0%
(During the recovery, UPRO seems to be back to 3.0x leverage again)

An LETF falling from 3.0x leverage to 1.8x leverage looks like volatility drag.  But volatility drag can't explain 3.6x leverage - and neither of these fits the academic models that assume fixed leverage over time.  So I don't have a good model for what happens inside LETFs, but at least I can discount other models that don't explain real world data.

I invest in real world ETFs, not models, and the real ETFs don't match the models.  Still, I plan to exit several leveraged ETFs this year as the recovery takes hold.

I'm open to reading other articles and papers.

vand

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Re: How are you diversifying against sector concentration in index funds?
« Reply #23 on: February 21, 2021, 11:35:54 AM »
You turn to the dark side (aka Active Investing)

or you could buy SP500EW tracker XDWE
« Last Edit: February 21, 2021, 11:38:30 AM by vand »

Telecaster

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Re: How are you diversifying against sector concentration in index funds?
« Reply #24 on: February 21, 2021, 01:58:31 PM »
OP, you might like Personal Capital's investment strategy. PC seems to be making an attempt to overcome the 'limitations' of index funds you bring up. Personally, I'm quite content owning shares of companies based on their market capitalization. The fact that Big Tech is heavily weighted in VTI and SCHB, right now, seems like a complete non problem to me.

Can you give me the 40,000 foot view of the Personal Capital approach.  I can't view it without creating an account (or at least I don't think I can). 

Shane

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Re: How are you diversifying against sector concentration in index funds?
« Reply #25 on: February 21, 2021, 09:43:40 PM »
OP, you might like Personal Capital's investment strategy. PC seems to be making an attempt to overcome the 'limitations' of index funds you bring up. Personally, I'm quite content owning shares of companies based on their market capitalization. The fact that Big Tech is heavily weighted in VTI and SCHB, right now, seems like a complete non problem to me.

Can you give me the 40,000 foot view of the Personal Capital approach.  I can't view it without creating an account (or at least I don't think I can).

Found this for you. It didn't seem to require a login to view:

"Our investment methodology is built upon sector and style weighting, risk minimization, and tax optimization. Weíll build a personalized portfolio based on your unique situation and goals."

Personal Capital Investment Strategy

Radagast

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Re: How are you diversifying against sector concentration in index funds?
« Reply #26 on: February 21, 2021, 10:43:52 PM »
I started a thread a little while ago that might give some ideas.

https://forum.mrmoneymustache.com/investor-alley/portfolio-design-idiots-v-gurus/

RobertFromTX

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Re: How are you diversifying against sector concentration in index funds?
« Reply #27 on: February 22, 2021, 11:52:26 AM »
I've found that a high-yield stock index fund like VHYAX or VHY (ETF) offer some sector diversification while still sticking with index funds. The high dividend stocks are typically consumer staples, banks, and energy production/pipelines. I don't even care about the dividend, its just sector diversification.

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #28 on: February 25, 2021, 09:57:30 AM »
I think I've decided what I'm going to do with this.  I'm looking to somewhat balance sectors and small cap/large cap within my domestic stock portfolio, while balancing against too much complexity.  In my domestic stock portfolio (50% of my total portfolio), I am currently:

50% SCHB- Total Market Fund (cap weighted)
50% SCHA- Small Cap Fund (cap weighted)

I think I'm going to move to:

40% SCHB
40% SCHA
5% RYE- Equal Weight Energy ETF
5% RYU- Equal Weight Utilities ETF
5% RTM- Equal Weight Materials ETF
5% RHS- Equal Weight Consumer Staples ETF

While this won't give me anything near equal weighting, it will balance out the most underweight sectors in my portfolio.  I won't be selling anything due to tax considerations, but I will be adding to my positions until I hit this allocation.

The only piece I'm a bit torn about is using the ETF's vs. picking some individual stocks (at random) myself.  I understand why these funds have expense ratios of 0.4%.  But I could also do it myself for cheaper, and in a more tax efficient way.


MustacheAndaHalf

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Re: How are you diversifying against sector concentration in index funds?
« Reply #29 on: February 26, 2021, 03:24:46 AM »
NorCal - Are you considering individual stocks because you won't pay commissions?  If so, it's likely you can also buy Vanguard ETFs for free.  If you can give up the equal weight aspect, Vanguard Energy (ETF) and other ETFs might work.

There's also other sector ETFs out there, hopefully you find one with lower expenses:
https://etfdb.com/etf-education/the-10-sectors-of-the-stock-market/

NorCal

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Re: How are you diversifying against sector concentration in index funds?
« Reply #30 on: February 26, 2021, 06:05:16 AM »
NorCal - Are you considering individual stocks because you won't pay commissions?  If so, it's likely you can also buy Vanguard ETFs for free.  If you can give up the equal weight aspect, Vanguard Energy (ETF) and other ETFs might work.

There's also other sector ETFs out there, hopefully you find one with lower expenses:
https://etfdb.com/etf-education/the-10-sectors-of-the-stock-market/

Thatís a good point. My search was probably a bit too narrow. Iíll take a look before I buy. Thanks!