Fine-tuning index fund positions

Question

In general, passive mutual funds (as well as ETFs) provide a good way to diversify without keeping track of and/or a large number of separate securities or paying high additional expenses.

However, many of the best-known indexes tend to be weighted on market capitalization, which increases exposure to movements in the biggest holdings, somewhat undoing diversification.

For example, QQQ (tracks Nasdaq) has 44% of its value invested in only 5 companies.

If I want a bigger share allocated to Texas Instruments than the 1.34% that QQQ puts in there, the solution is straightforward: buy some shares of TXN.

But if I think 11% in Apple or 5% in Facebook is too much, what can I do?

One option is to find a fund with a different weighting. Those, even the ones with a passive indexing rule, tend to have higher expense ratios (compare QQQE at 0.35% to QQQ's 0.15 or VADDX at 0.28% to SWPPX at 0.03%). Admittedly, a 0.25% difference is not that much in absolute terms, but in relative terms it's a factor of 9X. Also, the differently-weighted funds may not be offered commission-free by my broker.

Ideally it would be possibly to simply own negative shares in these companies over the same time period as the index fund. There's no risk, because any losses on the "negative shares" are made up for by the profits made by long positions within the index fund (although they can't be separated from the fund, which has potential drawbacks of its own).

Here it is suggested that the solution would be "put" options. But those expire and must be repurchased, so it seems like a very time-intensive approach.

Is there a way to offset against positions held in an index fund in a long-term manner? Or is my only hope continuing to screen funds to find one that very closely matches the allocations I want?

Answer 1

The best solution to your problem is to find an ETF that has a more suitable weighting.

Now, let's dive into the weeds with the long put idea to reduce ETF component weighting. A standard option contract is for 100 shares. In order to have 100 shares of weighting in the QQQ, you'd need about 900 shares of it (QQQ price x 900 x 11.6 AAPL weighting / AAPL price). So for smaller positions, puts are out unless you use mini options.

Last I knew, the SEC approved mini options (10 share contract) on AAPL, AMZN, GOOG, SPY and GLD. So in this case, the bar is low at 90 shares of QQQ. But in other cases, not viable unless you hold size. I utilize standard options so I have no clue what minis exist or if they are liquid or if the B/A spreads are reasonable.

If 900 shares of QQQ equals 100 shares of AAPL then every 100 shares of QQQ represents 11 shares of AAPL. So you could buy one mini AAPL put for each 10 shares of AAPL that you want to offset. But if AAPL didn't have mini options, you could only titrate your QQQ position in 100 share component increments so it would be impossible to achieve a specific weighting.

In general, it usually costs about 6-7% a year to hedge a portfolio with index related options. The average implied volatility of stocks like FB, GOOG and AAPL is ~25% higher than QQQ so that makes their options more costly to utilize, perhaps 8-9% per year. Given recent market turbulence, IV is up across the board for all of them, even more so for FB which is under political as well as market pressure (IV has nearly doubled in the past week).

Regardless of the manner of put hedging, 6-9% per year is a lot of drag on a portfolio. Granted, you're only going to be hedging a small portion of your ETF's holdings so this is just an attempt to put the cost of total hedging in perspective.

If you can't find a desirable substitute ETF then shorting specific holdings is an alternative. You can short the exact number of shares that correlates to the percentage of an ETF's holdings that you want to offset. Just be aware that there are share borrow costs - they are fairly low with with large caps. In addition, you pay out dividends if you are short the shares on the ex-div date (which might not bother you since there's the offset from the ETF shares).

So coming full circle, the best solution to your problem is to find an ETF that has a more suitable weighting. If not commission free, bite the bullet because the weighting will affect you more than a $4.95 commission (typical discount broker).

Answer 2

Bob Baerker's answer is great and addresses what you asked, but I wanted to challenge the assumption in your question. While you say that market cap weighting reduces your diversification because of the weight of the top holdings, I'd say market cap weights are the most diversified way of investing in securities.

To illustrate, let's say the market only has companies A, B, and C, each a third of the total market weight, and you hold them in those proportions. If company A and B merge together to form company AB, would you be any less diversified? I'd say no, you're still invested in what's essentially 3 businesses in 2 publicly-traded securities.

There's minor exceptions to this:

• Catastrophic losses in the 'A' or 'B' division could now spill over and affect the profits of the company as a whole. However, there's usually layers of limited liability holding companies preventing this.
• A and B are now under the same "brand" and share a CEO and board, so bad publicity or criminal actions by execs could hurt them.
• More of an inconvenience than anything, but you can't sell A without selling B, and viceversa.

However, in general, no, you still own essentially the same 3 "businesses" in 2 publicly-traded stocks.

You could do this in reverse. Apple spinning off their iPhone and iPad divisions into their own companies would not make you more diversified overnight. The danger of slowing iPad sales (while iPhone sales remain steady) would affect you equally in both cases.

You can take the example to the extreme by imagining one company (company Borg) merging with every other publicly-traded company in the market. The only independent company left is one tiny micro-cap (company Z) that has cornered the market of baseball caps. If you held these 2 companies in equal proportion, I'd argue you'd be very undiversified, as you'd be highly exposed to one niche business. Holding only company Borg would make you slightly undiversified, since you own every business type except baseball cap retail. Market cap is the only way to ensure maximum diversification.