Are Market-Cap-Weighted Portfolios Sufficiently Diversified?

The two essential requirements of an investment fiduciary are to maintain costs at a reasonable level and to diversify the assets. The purpose of the latter is to minimize or eliminate unsystematic risk, leaving only systematic risk. Examples of unsystematic (or diversifiable) risk include risks associated with specific companies, industry groups, and countries. Examples of systematic (or non-diversifiable) risk include market risk, interest rate risk, and inflation risk.

Based on the Capital Asset Pricing Model (CAPM), the most efficient portfolio (the one that maximizes expected return relative to risk assumed) is the market portfolio, which is the total market weighted by market capitalization. CAPM is subject to two major criticisms. First, it is based on an idealized set of assumptions (e.g., no taxes, no trading costs, and perfectly rational investor behavior). Second, it doesn’t do a very good job of explaining portfolio returns—beta, the CAPM risk measure of market sensitivity, explains about 70% of the variation of returns.

Using the iShares Core S&P Total U.S. Stock Market Index ETF (ITOT) as a proxy for the market portfolio (assuming U.S. only), Apple Inc. would be 3.2% of the portfolio while Campbell Soup would be only 0.04% (according to ishares.com as of 9/14/2017). In other words, our market portfolio would have 80 times as much exposure to Apple. Thus, one may conclude that our market-cap-weighted portfolio has failed to minimize (much less eliminate) unsystematic risk. Clearly, it has far more exposure to the specific risks of the larger companies. Perhaps if we were to equally weight the companies, then we would truly eliminate the unsystematic risk. As tempting as it may sound, this approach creates more problems than it solves.

First, a basic and inescapable fact of investing is that all investors together own the cap-weighted market portfolio. If one or more investors insists on owning the equal-weighted portfolio, then there must exist a group of investors that is willing to own a portfolio that is even more heavily weighted in the larger companies than the cap-weighted portfolio. A reasonable question to ask is what compensation would this group demand to accommodate the equal-weighters in constructing their desired portfolio? Please note that there is zero reason to believe that the equal-weighters are somehow smarter than their trading counterparties. There is also zero reason to believe that larger companies are more likely to be “overvalued” compared to smaller companies.

Second, while a cap-weighted portfolio is very easy and inexpensive to maintain, the same cannot be said for an equally-weighted portfolio. Going back to our two-stock example, no matter how much the prices of Apple and Campbell Soup move, a cap-weighted portfolio remains in balance, with no trades needed, while an equal-weighted portfolio will almost certainly require rebalance trades.

Third, while an equal-weighted portfolio might have lowered the level of unsystematic risk, it has only done so at the cost of introducing another type of risk—the risk associated with smaller companies which are more heavily represented in the equal-weighted compared to the cap-weighted portfolio. While there is nothing wrong with intentionally taking on small cap risk, particularly since it is expected to be compensated with a higher expected return, Investors should not be deluded into thinking that they have somehow beaten the system by using an equal-weighted portfolio.

To conclude, we at Clarity are not of the opinion that everyone should own the market portfolio. We deviate from it ourselves in pursuit of the higher expected returns associated with small cap, value, and highly profitable companies. However, we do not believe that by using a cap-weighted portfolio, an investment advisor or manager has somehow failed to meet the duty and care required of a fiduciary. If you would like to learn more about the investment fiduciary services provided by Clarity Capital Advisors, please call us at 800-345-4635 or e-mail us at info@clarityca.com.