Diversifying diversification.

We want to talk about diversification today. Actually, diversification of diversification. Pretty meta, right? Well, you're in for a slightly meta day today. We are trying a different approach in talking about the benefits of diversification.

When you pick a stock, you choose a living, breathing entity. You buy a piece of a live business with employees, who have aspirations and CEOs with a vision they want to execute. But essentially, you're trying to predict the future. But can you, though.. predict the future?

Reliably, no. Here's why.

Edward Lorenz, an MIT mathematician, was trying to make weather predictions. He found that little changes in the initial conditions would significantly affect predictions or outcomes. For example, a butterfly flapping its wings in Brazil could theoretically cause a tornado in Texas. Lorenz called this the 'butterfly effect. So chaos theory, when applied to financial markets, says that insignificant changes can have a massive impact on long-term outcome of markets.

How is this relevant to what we are going to talk about today? Our thesis is building up, we’re getting there.

Let's talk ETF's first, a great method for diversification. And Vanguard500 is the king of index funds as it tracks the S&P500. And what exactly are ETFs >

• ETFs are traded on the stock exchange just like stocks and other commodities.

• They have certain advantages on individual stocks as they can offer innate diversification of sectors, can be done with a passive investing approach, and are considered safer investments when compared to individual stocks.

• ETFs can also be sector or index specific. Here are some examples of common sector specific ETFs.

Let's look at the VOO a little closer and also ETFs in general.

An ETF's price is guided by market capitalization and the concentration of the individual stocks it's composed of. For Vanguard's S&P 500 (VOO) ETF, the top five holdings are Apple (7.1%), Microsoft (6.2%), Alphabet (3.4%), Amazon (2.7%) and NVIDIA (2.0%). Going sector by sector, Technology is about 26%, healthcare is 14.2%, financials are 12.9% and other sectors (consumers, industrials, energy, real estate, etc)form the rest. You can find the details here.

Warren Buffett, while talking about Vanguard S&P500 said: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds."

Enter Chaos theory

So before we connect all this back to chaos theory, let us make this very clear. S&P500 is a great investment. And Warren Buffet is absolutely right. But, we will dare to make a small comment to what he says about VOO. If you look closely into VOO, you will see the weights of stocks aren't exactly equal.

For every $1,000 we invest in VOO, about $71 is invested in Apple, $62 is invested in Microsoft, $34 in Alphabet and so on. This means that VOO will invest about $260 in the IT sector, $129 in banking and financials, $142 in healthcare and so on.

This is more of a bet. A prediction that technology stocks will always perform well in the future. Software companies will always perform long in the future. Is there a possibility that this maybe untrue, like we see in chaos theory. Not only is it a possibility, it has already happened. In 2022, with fears of inflation technology stocks got hammered and fell by more than 30%. This could happen in the future, whether it is geopolitics, natural disaster or some other issue we think is insignificant.

So what are we saying.

Diversify diversification. Lol.

Of late, many investors have been looking at other options to tackle this issue, and hence the concept of equal-weighted index evolved. The Invesco S&P 500 Equal Weight ETF (RSP) handles this issue by employing a more balanced approach by equally splitting the invested amount across all 500 stocks of the S&P 500.

Let's come back to our earlier example of investing $1000 and see how the money gets invested now. A $1000 will now split itself into $1000/500 companies in the S&P 500 = $2 in each of the 500 companies.

2022 was the year in which the tech sector underperformed, but several other sectors, such as consumer staples, travel, and energy, were still giving good returns. This meant that the market cap weighted VOO dropped by 18.91%, whereas the RSP dropped by only 11.6%. Here is a chart showing the individual year returns of RSP compared with VOO.

It is not guaranteed that the equal weighted ETF will always produce better returns than the market cap weighted ETF. The objective of the ETF is to offer a hedge for your investments when particularly dominant sectors of the market cap weighted ETFs are underperforming.

It would make sense to have a portion of your index fund investments in the form of equal weighted indices.

Equal weighted ETFs upside :

1. They offer greater diversification than market-cap weighted index funds. This is because equal weighted ETFs invest in a wider range of stocks, including smaller cap companies which are often overlooked by market-cap weighted ETFs.

2. Equal weighted ETFs have a higher potential to outperform market-cap weighted ETF over the long term. As explained earlier, they have a unique advantage of being less sensitive to the performance of large cap or in some cases overvalued stocks.

3. They can provide some hedge in case of bad performance of heavily weighted sectors such as financials or IT.

Equal weighted ETFs downside :

1. While the greater diversification offers hedge, it also increases volatility when compared to market-cap weighted funds. Simply because, their performance is not guided by the heavy weight large cap stocks.

2. These funds are slightly less liquid than market-cap weighted funds. This means that it is more difficult to buy and sell shares in these funds.

3. Since the distributions within an equal weighted index need to be balanced on a frequent basis, this fund is more actively managed compared to the market-cap weighted funds. This results in higher expense ratios. For example, the expense ratio for RSP is 0.20% whereas for VOO, it is 0.03%.

Here are some examples of equal weighted ETFs you might want to look into.

1. Invesco equal weighted S&P 500 ETF (RSP)

2. iShares MSCI USA equal weighted ETF (EUSA)

3. Vanguard S&P 500 equal weight ETF (EWUS)

4. Schwab S&P 500 equal weight ETF (RSW)

5. State Street S&P 500 equal weight ETF (RSPE)

I know we digressed longer today than usual, but let us know what you thought about this weekly.

The information provided here is for entertainment purposes only, does not constitute financial advice, and should not be used for making investment decisions; you should consult with a professional advisor for such advice tailored to your specific circumstances.