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Total Market Index vs. Sector Investing

By JLP | November 28, 2007

Take a look at the graphic below, which is the sector allocation of the iShares DJ Total Market Index Fund (IYY):

Notice anything significant about that allocation? I’ll give you a hint: it’s the fact that over 17% of the fund is allocated to the financial sector. Unfortunately, financial stocks have been hammered this year. It shows in the performance of IYY, which is up around 4.97% YTD at the time of this writing.

That’s why I prefer to invest equal amounts in the ten sector funds that make up the total market index. As the table below shows, it’s impossible to know which sectors are going to perform the best from one year to another:

Dow Jones Total Market Index Sector Total Returns 1992 - 2006
Click to view in a larger format

The equal allocation strategy would have worked out nicely this year since it limited the exposure to the financial sector to just 10% of the portfolio. Here’s the numbers for 2007:

Please note that this strategy might involve greater transaction costs since you are buying 10 funds instead of just the one fund. So, transaction costs need to be considered before going with this strategy. One way around these transaction costs is to use a low-cost brokerage firm or even a brokerage account that charges a flat fee like FOLIOfn. Still these options are only helpful if you have a decent-sized account.

Another factor to consider is taxation on the buying and selling of the sectors if the portfolio is held in a taxable account. Therefore, it’s probably best to use this sort of strategy inside a tax-sheltered account like an IRA or Roth IRA.

In a follow-up post, I’ll show you how the rebalanced portfolio performed over the years. Stay tuned…

Topics: Exchange-Traded Funds, Index Funds, Investing | 16 Comments »


16 Responses to “Total Market Index vs. Sector Investing”

  1. JB @ GetRichOrDieTrying Says:
    November 28th, 2007 at 4:49 pm

    This was very informative! Thanks. I am very new to investing and learning a great deal. I thought IYY would be a good investment (and like you say, it still might be), but this really opened my eyes to what’s behind it. Thanks!

  2. Ryan Says:
    November 28th, 2007 at 6:34 pm

    I hope to read your follow up. You really didn’t explain why this would work better than a traditional cap weighted index, other than the fact that the most overweighted sector (financials) underperformed this year. You’re just overweighting small sectors. Is this an attempt to buy sector stocks on the cheap (like buying value stocks)? But unlike value stocks, small sectors may be small by their nature (different economic demands) rather than low P/E, P/B etc.

    Anyway, I imagine you’ll cover this in your follow up, but I’m very interested. Thanks! Always love reading your posts.

    Ryan

  3. jb Says:
    November 28th, 2007 at 7:53 pm

    Agree with Ryan, you’re really just overweighting smaller sectors. Depending on how you define your sectors, you could end up with a very strange risk profile. I could define one sector as “Financials” and another as “Carbon Fiber Producers”, but that would way overweight a few small companies and underweight the financials.

    Anyway, I love the chart, really underscores that people should not be trying to outguess the market, things change so much every year.

  4. muddlehead Says:
    November 28th, 2007 at 8:54 pm

    “That’s why I prefer to invest equal amounts in the ten sector funds that make up the total market index.” i hope you’re joking. how often would you have to adjust to keep ‘em equal? you know what i’m about to say, so i won’t deny you. this ain’t too hard. dollar cost average into a no load total stock market index fund for you equity allocation. period. bad use of brain cells to over-think or over-analyse. some times simple is best.

  5. JLP Says:
    November 28th, 2007 at 9:14 pm

    Muddlehead,

    Rebalance once a year.

    I don’t see what the big deal is. You’re still buying the total market – just in ten chunks instead of one fund.

    If what you are doing works for you, then keep doing it.

  6. Zook Says:
    November 28th, 2007 at 11:20 pm

    Hey-

    As little as it may seem, adding in those final sentences in a little disclaimer made my day and shows a level of trust your readers should have with you and your blog.

    You gave some great ideas and strategy buying 10-sector ETF’s over one ‘oddly’ weighted IYY fund, but made sure to add in some of the negatives that would be involved in a taxable account with a small egg of money.

    Good stuff JLP!!!

  7. Zook Says:
    November 28th, 2007 at 11:20 pm

    Love the pdf of the S&P 500 sectors…That is awesome…

  8. muddlehead Says:
    November 29th, 2007 at 12:31 am

    “If what you are doing works for you, then keep doing it.” back at ya, bra :)

  9. MossySF Says:
    November 29th, 2007 at 4:47 am

    It may be out of weight to the total stock market but the degree of difference isn’t that significant. What you do get is the rebalancing bonus — sectors go through booms & bust all the time. Holding a cap weight index means you go up and down with them while equal sector weight allows you to skim off profits during booms and increase your share in sectors when they are bargains.

    The tradeoff is taxes and trading expenses. Instead of buying VTI at 0.07% ER, you end up holding iShares sector ETFs at 0.50% and Vanguard sector ETFs at 0.25%. Add in trading fees, taxes for rebalancing in taxable accounts (when you don’t have new money to rebalance) — it probably isn’t too far off from holding the total market anyways. In return for the extra complexity, what you do get is lower volatility from rebalancing and keeping your AA on target even when the overall market AA has gone totally out of balance.

    Rydex also has several equal weight ETFs which does all the rebalancing work for you but you can’t control the allocation or optimize reblancing by using new contributions. On the otherhand, it’s an easy shortcut under an IRA brokerage account.

  10. Get Rich Or Die Trying » Blog Archive » 5 Posts From Around The Web (Week of November 26, 2007) Says:
    November 30th, 2007 at 8:34 am

    [...] Total Market Index vs. Sector Investing – JLP @ AllFinancialMatters looks at what’s behind IYY and why it might be better to invest in separate sector funds. [...]

  11. Mike Says:
    November 30th, 2007 at 9:02 am

    check out kudlowsmoneypolitics.blogspot.com and scroll down to Kudlow 101 to see how international vs. US investing has fared. Facinating.

  12. » Beware Hindsight in Investing Strategies on Blueprint for Financial Prosperity Says:
    November 30th, 2007 at 4:51 pm

    [...] JLP wrote a post today about how he prefers to invest in each of the market sectors equally, instead of going the route of some total market funds and weighing them based on market capitalization. He illustrates this point by highlighting the fact that the iShares DJ Total Market Index Fund (IYY) has over 17% invested in the financial sector, which has been taken out to the woodshed as of late. See? His strategy of equal weight has prevailed! [...]

  13. Swim Upstream to Wealth Says:
    December 2nd, 2007 at 9:25 pm

    This is a unique idea, but I fear that the transaction and tax consequences will eat up the difference between the strategies. Of the three factors that make up your return (asset class performance, fees, taxes), you control two of them – fees and taxes.

    The other factor to consider is by buying equal segments of each sector you will reduce the market cap size of your holdings. This means you holdings may look more like a mid-cap fund than a large cap (or at least it will lean that way). Historically, the smaller the capitalization the higher the return…and also the risk.

  14. Total Market Index vs. Sector Investing - Part 2—� AllFinancialMatters Says:
    December 3rd, 2007 at 1:00 am

    [...] As promised, here’s my follow-up to last week’s post, Total Market Index vs. Sector Investing. In that post, I mentioned that a spin on investing in the Dow Jones Total Market Index (TMI) would be to buy equal allocations of the ten sectors that make up the TMI and rebalance them annually. I also mentioned that such a strategy would have performed quite well this year since the strategy would have only held a 10% stake in the financial sector while the TMI had a 17% allocation. [...]

  15. Weekend Update: Dark and Stormy Night Edition ∞ Get Rich Slowly Says:
    December 3rd, 2007 at 1:38 am

    [...] At heart, JLP is a numbers nerd. Recently at All Financial Matters, he’s been comparing the performance of a total market index fund to investing in ten sector-based funds instead. Yes, it’s geeky, but I actually find it kind of interesting. [...]

  16. Allison Says:
    January 10th, 2008 at 2:38 pm

    Hi JLP,

    I am a conference producer with Financial Research Associates and am producing our 8th Annual ETF Summit. I would like to talk to you about your sector strategy using ETFs.

    If you are amenable please email me and we can establish a time to discuss.

Comments