Index Funds and Sector Diversification

[catccc]

Hoped to get some thoughts on sector allocation when your primary mode of investment is index funds.  Obviously market capitalization weights mean index investors hold tech positions heavily.  Tech stocks are down and energy stocks are up this year.  Of course, oil companies like Exxon and Chevron are killing it with very high returns since they are doing what feels like price gouging. 

Admitting that this thinking has been brought about a call with personal capital, wherein I was told my "index and stay the course" method was no good in the current environment.  They told me the same in late 2020 and obviously we know how the next year turned out.  I'm not trying to be emotionally highjacked by them, but I do want to do my due diligence and will be looking into sector diversification more.  Interested in other perspectives!

[MDM]

See Callan periodic table of investment returns - Bogleheads.   What does that suggest to you?

[catccc]

Thanks, but asset class diversification isn't the really the same as sector diversification, right?  So the question is, should sector diversification be addressed?

Even in the Callan example, given that asset classes are all over the place on the table, doesn't that suggest that one should not be heavily weighted towards any one asset class, and with index investing, you are heavily in large cap equities?

[MDM]

Perhaps the Callan message is reinforcement of "past results are no guarantee of future performance" and "successful market timing is very difficult to do on a long term basis."

[catccc]

I really like the simplicity and ease of indexing, but your note on the Callan message seems to support that sector diversification is important.  Techs have done well in recent history, that doesn't guarantee that will continue, of course.  So if traditional indexing puts 25% of your assets into tech, isn't that not diverse enough?  Or is "enough" just relative, anyway, so it just depends on personal preference?

I really doubt I'd ever put any of my assets under personal capital's management for this.  But I'm wondering if I should stop buying VTSAX and contribute to VMIAX and VENAX for a bit to even out sector allocation.  I'm not trying to time anything, not inherently, at least.  I am just trying to sector rebalance via new contributions. 

[MDM]

I really like the simplicity and ease of indexing, but your note on the Callan message seems to support that sector diversification is important.

One may read into it what one wishes. 

Nibbling around the edges by tweaking things here or there is unlikely to make much difference, either up or down, but if it is enjoyable then go for it. :)

[MDM]

There is also the Slice and dice - Bogleheads wiki article for consideration.

"Right" or "wrong" in this context will only be known in hindsight. ;)

[LightStache]

Maybe a year ago I switched my S&P500 allocation to an equal weight ETF. First GSEW, then RSP.

There's nothing that inherently ties indexing and cap weighting together except that cap weighting is just the most popular.

I think there's merit in the idea that the rise in popularity of index investing may be increasing systematic risk for megacap stock prices. It's a cycle where the indexers buy more megacap stock because of the weighting, which in turn increases the cap, which increases the weighting, which causes indexers to buy more, and so on. If that cycle were to be interrupted, the price inflation could unwind dramatically. So I moved to equal weight to mitigate that risk in my large cap allocation.

My portfolio still has it's highest sector allocation to tech, 24%. That doesn't strike me as a problem. If it was 75% then yea, I'd probably do something about it. But until there's a valid reason to increase or decrease sector allocations -- timing isn't a valid reason for me -- I'll just let it ride.

[MustacheAndaHalf]

There's nothing that inherently ties indexing and cap weighting together except that cap weighting is just the most popular.

Market cap weighting has lower turnover.  When a stock doubles and another falls, market cap weighting does nothing.  But equal weight ETFs like RSP rebalance quarterly, so they need to sell half the stock that doubled, and buy more of the stocks that fell.  Note that within a quarter, the weights actually drift according to price moves - just like cap weighted funds.  If you think equal weight is merely a preference, you can look into why equal weight funds don't rebalance more often.

I think there's merit in the idea that the rise in popularity of index investing may be increasing systematic risk for megacap stock prices. It's a cycle where the indexers buy more megacap stock because of the weighting, which in turn increases the cap, which increases the weighting, which causes indexers to buy more, and so on. If that cycle were to be interrupted, the price inflation could unwind dramatically. So I moved to equal weight to mitigate that risk in my large cap allocation.

Market cap consists of price times shares.  Prices change all day long, while share counts are stable for months - so it's mostly prices driving changes in market cap.  I dispute your claim that passive indexers drive the price of megacaps higher.

First, they buy equal percentages of all companies.  New purchases might be 0.01% of Apple and 0.01% of the smallest company in the index.  Passive indexing, by definition, is proportional.  It can't target megacap exclusively - that's not indexing.

Second, passive investors get involved rarely, while market makers and HFT firms are involved in the market all day long.  If passive investors all bought on one day, and a week later earnings come out, the company stock will reflect earnings - not what happened a week before.  So even if indexing wasn't proportional, it's a very small amount of price discovery in the market, and less significant than it looks.

So I disagree that passive investing is driving megacap prices higher while leaving other stocks unchanged.

[Car Jack]

From a metaphorical look, if you own the whole haystack, you get market returns.  If you decide to go looking for the needle, you pretty much are going to find hay strands and underperform for your effort.

That said, I have never wanted any of my money in China or Russia.  I do my best simply by having my international in VEA (developed international).  If Russia and China go nuts and skyrocket, that's fine.  I want nothing to do with them.

I'm not surprised that some talking head is saying to favor some sector or another.  I'm going to guess that THEY have money in that sector and it's in their best interest to get YOU to invest in that and raise the price, thus eventually giving them a gain and a point where they can bail out.  At that point, they'll invest in another sector and start screaming that this new sector is hot and that you should sell everything and go into it.  No thanks.

[Heckler]

  Tech stocks are down and energy stocks are up this year.  Of course, oil companies like Exxon and Chevron are killing it with very high returns since they are doing what feels like price gouging. 

My financial advisor from before I gave a shit about "retirement" had us buying Canadian energy funds as they'd been shooting up in the early 2000's, and when (after) they crashed, she had us sell and change over to high price US tech funds which had been killing it the past year.     Sounds a lot like what you're proposing - sell low, buy high.

I still shake my head and am happy that I own them all now, all over the world.  Not to even mention the FEL/BAC excessive fees those shitty sector mutual funds had.