I’d like to continue the discussion on investment risk (see “Managing Investment Risk” posted on June 21, 2010) by elaborating on diversification. Many investment professionals tend to refer to portfolio diversification as being synonymous with asset allocation. While closely related, there are distinct differences between these two concepts (as I hope to illustrate in this and the following post).
Readers of the earlier post will recall that diversification is a means to reduce non-systematic risk and asset allocation is used to reduce systematic risk. Basically, non-systematic risk relates to risk factors that impact individual companies (and, thus, individual stock prices), while systematic risk relates to factors that impact an overall segment of the market.
To illustrate this, I’m going to use BP as an example. I’m a bit reluctant to do this because by now BP is the poster child for so many ‘what not to do’ lessons that using it in yet another example seems almost clichéd. But the illustration is so timely and relevant to the concept of diversification that I can’t resist.
The chart below was obtained from Yahoo! Finance and shows the stock price performance of BP relative to XLE (Energy Select Sector SPDR ETF). XLE currently consists of the 39 companies in the S&P 500 that primarily develop and produce crude oil and natural gas, and/or provide drilling and other energy-related services. Some of the better-known companies held by XLE include ExxonMobil, Chevron, ConocoPhillips, Schlumberger, Halliburton, and Chesapeake Energy.
Two things are notable about this graph.
First, the dramatic decline in BP’s stock price as a result of the oil rig accident in the Gulf of Mexico can clearly be seen. The impact on the U.S. energy sector (XLE price), however, was much less pronounced.
Now to be fair, BP (as a foreign equity) isn’t included in the holdings of XLE. But it could have been. Or more accurately, a catastrophic event could have occurred (or may yet occur) at any of the companies held by XLE. This is the essence of non-systematic risk. We cannot know what future endogenous problems are lurking within one or more of any company’s business units or departments.
The second point to be made about the graph is that an investor who had purchased XLE at its inception in 1998 would have significantly outperformed the BP investor, even prior to the accident.
So given this illustration, why would a long-term investor purchase stock in a single company (BP) rather than in a sector fund (XLE)?
Perhaps for the dividend yield?
In the quarter just prior to the oil spill BP paid a dividend of $0.84, which is a yield of roughly 6% annualized based on BP’s stock price of about $57 per share on the date the dividend was declared.
By contrast, the yield on XLE was only about 1.4% annualized during the same quarter.
But as BP investors have learned, dividends are not sacrosanct. Following the Gulf oil spill, BP suspended dividend payments indefinitely. So today the 1.4% yield on XLE looks pretty good compared to the 0% yield on BP.
The point here is that by diversifying one’s investments across the 39 energy companies in the S&P 500, the suspension of dividends by any one or two companies does not mean the complete loss of yield for an income-oriented investor.
1. Index funds that hold a basket of stocks representing a particular sector or region reduce an investor’s exposure to catastrophic (i.e., non-systematic) events that can severely impact an individual company’s stock price.
2. By definition, catastrophic events cannot be predicted. Nor can their likelihood be discerned from financial statements, annual reports, analyst commentary, technical analysis charts, or any other publicly-available information used to determine a company’s value.
3. Thinking that large, well-known corporations that have been in operation for 50 years or more are ‘too big to fail’ can lead to a false sense of confidence. Consider GM, AIG, Lehman Brothers, GE, Merrill Lynch / Bank of America, Chrysler, or any number of individual companies that are either no longer in existence or have current valuations that are significantly below the valuations of their sector averages or the major indices (e.g., S&P 500).
4. In many cases, a fund such as XLE will outperform the largest holding in the fund. For example, currently ExxonMobil (XOM) is the largest holding in XLE, comprising a little less than 20% of the fund at the time of this writing.
Consider a comparison of XOM with XLE going all the way back to the fund’s inception in late 1998.
We see that XLE was outperforming XOM at almost all points in time. Even the dramatic drops in XLE in late 2008 and again in early 2009 brought its returns more or less into parity with XOM.
As of last Friday, an investor who had purchased XLE in late 1998 is enjoying a 125% return on her investment, while an investor in XOM is experiencing only a 50% gain.
One reason that index ETFs tend to outperform their largest holdings is related to the fact that the larger holdings tend to be value stocks with slower price growth. By holding all energy stocks in the S&P 500, smaller companies that have more of a growth potential are included as well.
The net effect, then, is that what XLE gives up in dividend yield is more than compensated for by its price growth. In short, holding an index fund like XLE allows an investor to take even further advantage of diversification by holding both value and growth stocks.
So how does an investor determine which index funds to purchase out of the 1000+ that are currently offered? Much of this depends on asset allocation. In my next post on investment risk, we’ll examine asset allocation in greater detail, and how it differs from diversification.
Full disclosure: The author holds both long and short positions in XLE and BP (by way of EFA, the iShares MSCI EAFE Index Fund) .