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Total Market Index vs. Sector Investing - Part 2
By JLP | December 3, 2007
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.
Unfortunately, I think my post was misunderstood as my endorsement of a strategy based solely on this year’s performance alone. I would never recommend anything based on 9 months worth of history.
Anyway, I promised to show you how my “strategy” performed in the past. Unfortunately, we don’t have a lot of history to go by since the iShares sector funds (the only way to invest in such a strategy) have only been around since 2000. That said, here’s a year-by-year ranking of the ten iShares DJ Sector funds along with the iShares DJ Total Market Index fund (IYY) as well as the strategy (Portfolio). You can click on the graphic to see a larget PDF.
And here’s a year-by-year comparison of the returns of IYY vs. the Portfolio BEFORE fees:
The strategy assumed that all dividends were reinvested and that the portfolio was rebalanced at the end of each year. The above graphic DID NOT include transaction costs so, I re-ran the numbers to include transaction costs. I assumed that the portfolio was housed at FOLIOfn under their basic plan, which costs $199 per year but gives account holders “free” trades each month. I did not factor in a transaction cost for trading IYY since it would only be purchased at the beginning of the hypothetical and would never need to be rebalanced. I also assumed that this strategy would be used inside an IRA so taxes weren’t an issue.
So, what did I find out? Well, on a smaller account of $10,000, you would have been better off investing in the iShares DJ Total Market Index fund rather than using the strategy. Why? Transaction costs! It turns out that the $199 annual portfolio fee really ate into the returns:
You might be saying to yourself, “That’s it! Game over! JLP’s strategy sucks!”
Well, not necessarily. You see, the strategy worked much better with a larger portfolio:
Using the strategy on a $100,000 portfolio shows that the strategy portfolio was worth nearly $10,000 more than the IYY portfolio. That’s because the $199 annual transaction cost was a much smaller hurdle to overcome.
This brings us back to the points I made at the end of the previous post: taxes and transaction costs are very important when making portfolio choices.
One final note before we end this thing: I did not include fixed income or international funds in this illustration. My intent was to only look at the total market index and the ten sectors that make up the index. This post is also not an endorsement of any strategy. Invest at your own risk.
UPDATE: Andy left an interesting comment below about how maybe the equal-weighted sector portfolio performed better because it had more value stocks or small-cap stocks. I went back and did some analysis and here’s what I found out:
As you can see from the chart, the size weightings didn’t change much at all. So, that tells us that any performance difference between the total market index and the sector portfolio was due to the sector allocations themselves. This makes sense to me since sectors are always falling in and out of favor and weighting the sectors equally allows a portfolio to take advantage of that fact.
Topics: Exchange-Traded Funds, Index Funds, Investing |
December 3rd, 2007 at 1:12 am
It seems that the difference in performance is likely because your “equal weighted” portfolio has more invested in small and/or value stocks.
December 3rd, 2007 at 2:53 am
[...] Total Market Index vs. Sector Investing - Part 2By JLPI assumed that the portfolio was housed at FOLIOfn under their basic plan, which costs $199 per year but gives account holders “free” trades each month. I did not factor in a transaction cost for trading IYY since it would only be …AllFinancialMatters - http://allfinancialmatters.com [...]
December 3rd, 2007 at 9:34 am
Another point to keep in mind is the different buy/sell behavior of equal-weight indexes versus market-cap indexes. In an equal-weight scenario, shares are sold when they go up and bought when they fall. In a market-cap scenario, they are bought when they go up and sold when they fall, not the ideal strategy! (Although they may benefit from momentum if your rebalancing period is fairly short.)
Anyway, another good example to look at is the equal-weight S&P 500 index, RSP, versus the normal version, SPY. Looking back to 2003 when it started, it has significantly outperformed the S&P 500 due to the buy-low sell-high strategy: http://finance.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1196715600000&chddm=453560&cmpto=AMEX:SPY&q=AMEX:RSP
December 3rd, 2007 at 12:33 pm
Jon - A cap-weighted index fund does not buy shares as prices go up and sell as they go down. If the price of a company goes up, so goes it’s capitalization, and that’s why the relative weight increases, not because more share are purchased. Also, equal weighting has not out performed in recent years do to rebalancing. It has out performed because it happened to be overweight in out performing sectors and underweight the under performing sectors relative to the cap-weighted market. There have been and will continue to be periods of time that equal weighting will under perform.
December 3rd, 2007 at 3:58 pm
Nice analysis! A really great work!
Cheers,
Pierluigi Rotundo
December 7th, 2007 at 10:25 am
[...] JLP at AllFinancialMatters has a good multiple part post about Total Market Indexes versus Sector Investing. It is something that I have not thought of before in my own portfolio, at least from an index perspective. [...]
December 12th, 2007 at 3:10 pm
[...] To Lily’s excellent analysis, I might add that one thing I like about ETFs is that they can be sliced and diced (if slicing and dicing is your cup of tea) in ways that mutual funds cannot (read this post to see what I’m talking about), which can allow an investor to create customized portfolios. [...]