Diversified At 15 Holdings?

Cam Hui from Humble Student of the Market posted a recap and link to an article from the Global & Mail by Avner Mandelman that made the case for a diversified portfolio only having 15-20 holdings. The number is not particularly shocking but I thought it might be interesting to deconstruct that number to see if it is practical for do-it-yourselfers and to see what it might look like broadly speaking.

The idea with a small number, although not how it was stated in the article, is to "put all your eggs in one basket and then watch the basket very closely." This can be an effective use of time because it is easier to keep tabs on 15 or 20 holdings than 50. The article cites research from Meir Statman that concludes there are diminishing returns from diversification passed 16 holdings.

So if one builds a portfolio at the sector level and uses the S&P 500 as a benchmark then I suppose there could be as few as ten holdings--there are ten big sectors in the SPX. If one simply buys each Sector SPDR in proportion with the SPX then all that has been done is to recreate the benchmark expensively but that is the starting point for construction of a portfolio; here is the index what are you going to do differently?

So without worrying about specific proportion versus the index (which quickly becomes a compliance issue) one can look at each sector and decide whether they are better off with the SPX components from that sector, this is what the Sector SPDRs own, or some other ETF (for this part of the post lets just focus on ETFs). For example, instead of the Utility Sector SPDR (XLU) someone might feel that the SPDR Global Infrastructure ETF (GII) which is about 85% utilities without much overlap with XLU or maybe the SPDR International Utilities ETF (IPU) would be better.

Each sector could be studied to assess where value might be added versus the Sector SPDR. I would note that value could be solely seeking outperformance or looking for a risk adjusted result. The example above with utilities covers the fund-ground that one could explore; plain vanilla with XLU, plain foreign with IPU and a niche or theme with GII.

The idea of adding themes in this way is very important. Infrastructure lends itself to being proxies for several sectors including industrials and utilities--the EG Shares China Infrastructure ETF (CHXX) could be a proxy for real estate (not a way I would want to go but as an example). I read something yesterday about Steel ETFs which could be proxies for the materials sector, there are of course other examples. Some country funds are so heavy in one sector that they too can be proxies for sectors; iShares Singapore at 50% in financials and client holding iShares Peru (EPU) being 65% materials as examples.

Using only one ETF per sector may not be such a great idea at least not with all ten. Whereas utilities, materials and telecom are all between 3-4% of the benchmark I think just one holding for those is just fine, assuming some weight close to the benchmark. The other seven sectors range in weight from 10.3% to 18.7% of the index. Using two holdings for each of those seven and one holding for the small three and that adds up to 17 holdings which is close enough to the 16 the Statmat cited.

For the sectors where an investor might try to get it done with two holdings there could be a core and explore sort of thing. Energy as an example some portion could go into something like the Energy Sector SPDR (XLE) with the explore perhaps targeting volatility like the Jefferies Wildcatter ETF (WCAT) or targeting yield like one of of the many MLP ETPs.

Hopefully it is obvious that anywhere above we could instead be talking about individual stocks although I would not want 9% each in two tech stocks which is what it would take to equalweight the sector. As far as where I stand on 15-20 holdings, while there is no right or wrong I prefer more than that. There are many countries, themes and attributes I try to embed into a portfolio and it would be difficult to do in just 17 holdings. While it is certainly possible that holding number 24 or 37 offers less utility than holding number 12 that does not mean that holdings 24 and 37 are useless either.

On a sort of related note last night we watched IRT Deadliest Roads which aired Sunday night on the History Channel. It is about some of the drivers from Ice Road Truckers trying to drive on roads that look a lot like the one pictured above that i thought were from Bolivia but now I am not so sure. Each of the truckers was hauling a load of cement up to the JP construction site where they are building a hydroelectric plant. I am pretty sure that JP is Jindal Steel and Power which you can find under the hood of several India focused ETFs including the EG Shares India Infrastructure ETF (INXX). It is interesting that the show is about India infrastructure.