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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 |