Do Low ER Index Funds Exist for Concentrated Small Sectors?

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MetaPhysician
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Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by MetaPhysician »

Hi all,

Been a BH for > 10 years. Thanks to the community.

I believe that index investing will provide me with better risk adjusted returns as opposed to picking individual securities. I do not have the time, knowledge, or desire to learn how to pick individual stocks.

I am entertaining using a very small percentage (~5%) of my asset allocation to take a take a concentrated bet/gamble in a concentrated sector.

It will be a one time contribution without pouring in additional monies.

If I always use index funds instead of individual securities why am I writing this question?
  • This space is a very small portion of the global market
  • This space is extremely volatile
  • This space is dominated by the top two assets (~80%)
  • There does not currently exist a 'pure' index fund according to a BH approach to market cap with a reasonable ER (currently they have a 2.5% ER whereas the one below is around 0.5%)
Proposed fund
  • invested in the top 20 assets by market capitalization
  • weekly rebalancing
  • A maximum component weighting of 10% for each asset
Questions:
1. Do you recommend I wait until a index fund arrives with a reasonable ER (and acknowledge it may never come to fruition)?
2. Do you recommend I create such a fund myself? I don't prefer want to do this since it involves time and I would prefer to invest and forget about it.
3. Is it possible to create an index fund of such a small concentrated sector? I've always looked at broad based mutual funds before and never looked at small sectors.
4. What do you make of the maximum weighting of the 10%? I understand that the top two assets will have less money than a pure market cap approach and smaller securities will be over-weighted.
livesoft
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by livesoft »

Did you just describe the service provide by M1 Finance?
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MetaPhysician
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by MetaPhysician »

livesoft wrote: Sat Jan 22, 2022 1:36 pm Did you just describe the service provide by M1 Finance?
Nope....but I'm sure someone will guess it correctly.
sycamore
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by sycamore »

MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm If I always use index funds instead of individual securities why am I writing this question?
...
- There does not currently exist a 'pure' index fund according to a BH approach to market cap with a reasonable ER (currently they have a 2.5% ER whereas the one below is around 0.5%)

Proposed fund
- invested in the top 20 assets by market capitalization
- weekly rebalancing
- A maximum component weighting of 10% for each asset
I don't understand. The "one below" is a proposed fund, so how does it have a 0.50% ER?
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 1. Do you recommend I wait until a index fund arrives with a reasonable ER (and acknowledge it may never come to fruition)?
If you really want an index fund, better to wait than try to build & maintain yourself, in my opinion.
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 2. Do you recommend I create such a fund myself? I don't prefer want to do this since it involves time and I would prefer to invest and forget about it.
No. I'm not even sure what you mean by "create such a fund" but the answer is no in any case!

To start with, if you want an index fund, you'll have to design the index. Your three bullet points are a start but there's more to designing an index than that.

Creating a mutual fund or ETF based on your index is also rather involved. The people who create such funds sufficiently knowledgeable about the process. There are lots of regulatory and reporting requirements. Maybe you mean something else by "create such a fund" ?
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 3. Is it possible to create an index fund of such a small concentrated sector? I've always looked at broad based mutual funds before and never looked at small sectors.
It is theoretically possible for index providers to index just about anything regardless of practical utility.

And there's been hundreds mutual funds and ETFs that came to market only to be shut down very quickly as they didn't gather enough assets to be successful. So in one sense it's possible to do lots of things but it's not very likely to succeed.

Maybe you're not asking about an actual mutual fund or ETF. In that case, Livesoft's suggestion of M1 Finance is probably more helpful. I have no idea what features M1 offers, but I'd guess it's more along the lines of automated portfolio management rather than "creating a fund."
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 4. What do you make of the maximum weighting of the 10%? I understand that the top two assets will have less money than a pure market cap approach and smaller securities will be over-weighted.
It's your index so you get to decide. Unless you're planning to do some backtesting / data mining to "prove" that one maximum weighting value was shown to provide optimal performance in a variety of conditions, your 10% limit is as good as anything else.
Northern Flicker
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by Northern Flicker »

Sector risk is diversifiable and uncompensated. If your goal is to reduce perceived sector concentration risk of market indices, then factor tilts, REIT tilts, and international diversification are the methods used and recommended by professionals.
000
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by 000 »

No they don't. I would just sample the space myself buying representative stocks.

I wouldn't rebalance either as it is fairly likely there will be one big winner and a bunch of losers.
Northern Flicker
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by Northern Flicker »

000 wrote: Sat Jan 22, 2022 3:24 pm No they don't. I would just sample the space myself buying representative stocks.

I wouldn't rebalance either as it is fairly likely there will be one big winner and a bunch of losers.
Or just a bunch of losers if sector risk materializes. You may get lucky and pick a winner, but the market does not discount in additional expected return because you chose not to diversify away sector risk and security-specific risk.
000
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by 000 »

Northern Flicker wrote: Sat Jan 22, 2022 5:31 pm Or just a bunch of losers if sector risk materializes. You may get lucky and pick a winner, but the market does not discount in additional expected return because you chose not to diversify away sector risk and security-specific risk.
I was referring only to relative performance to the sector not to broad market. The OP already told us he wants to tilt to a sector and you already warned him with your thoughts about diversifiable risk.

Question for you: why do you consider REITs a special case? Why factors?
quietseas
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by quietseas »

MetaPhysician wrote: Sat Jan 22, 2022 2:47 pm
livesoft wrote: Sat Jan 22, 2022 1:36 pm Did you just describe the service provide by M1 Finance?
Nope....but I'm sure someone will guess it correctly.
I think he meant you could use M1 Finance to set up pies to buy the stocks you want to hold in the allocation you define. Of course you'd need to do it in tax deferred whereas an ETF might be able to do it without capital gains distributions in taxable.
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by vineviz »

MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm
  • This space is extremely volatile
  • This space is dominated by the top two assets (~80%)
This doesn't sound like a sector where indexing makes any sense. Diversified mutual funds can't have 80% of assets in two stocks, and honestly you could replicate that index for free pretty well just by buying those two stocks plus or two more.

Ultimately it's going to play out more like a stock picking exercise than typical sector tilt, but at just 5% of your portfolio you're likely to lose a relatively small amount of money.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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MetaPhysician
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by MetaPhysician »

sycamore wrote: Sat Jan 22, 2022 2:50 pm
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm If I always use index funds instead of individual securities why am I writing this question?
...
- There does not currently exist a 'pure' index fund according to a BH approach to market cap with a reasonable ER (currently they have a 2.5% ER whereas the one below is around 0.5%)

Proposed fund
- invested in the top 20 assets by market capitalization
- weekly rebalancing
- A maximum component weighting of 10% for each asset
I don't understand. The "one below" is a proposed fund, so how does it have a 0.50% ER?
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 1. Do you recommend I wait until a index fund arrives with a reasonable ER (and acknowledge it may never come to fruition)?
If you really want an index fund, better to wait than try to build & maintain yourself, in my opinion.
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 2. Do you recommend I create such a fund myself? I don't prefer want to do this since it involves time and I would prefer to invest and forget about it.
No. I'm not even sure what you mean by "create such a fund" but the answer is no in any case!

To start with, if you want an index fund, you'll have to design the index. Your three bullet points are a start but there's more to designing an index than that.

Creating a mutual fund or ETF based on your index is also rather involved. The people who create such funds sufficiently knowledgeable about the process. There are lots of regulatory and reporting requirements. Maybe you mean something else by "create such a fund" ?
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 3. Is it possible to create an index fund of such a small concentrated sector? I've always looked at broad based mutual funds before and never looked at small sectors.
It is theoretically possible for index providers to index just about anything regardless of practical utility.

And there's been hundreds mutual funds and ETFs that came to market only to be shut down very quickly as they didn't gather enough assets to be successful. So in one sense it's possible to do lots of things but it's not very likely to succeed.

Maybe you're not asking about an actual mutual fund or ETF. In that case, Livesoft's suggestion of M1 Finance is probably more helpful. I have no idea what features M1 offers, but I'd guess it's more along the lines of automated portfolio management rather than "creating a fund."
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm 4. What do you make of the maximum weighting of the 10%? I understand that the top two assets will have less money than a pure market cap approach and smaller securities will be over-weighted.
It's your index so you get to decide. Unless you're planning to do some backtesting / data mining to "prove" that one maximum weighting value was shown to provide optimal performance in a variety of conditions, your 10% limit is as good as anything else.
Thanks, Sycamore.

1. The fund already exists able able to be invested in.
2. Sorry for being unclear I would not want to create this fund for public use - it would just be for me. I would pick the assets and rebalance accordingly, if I decide to go that route. M1 allows one to create a fund and then rebalance. However, I am unable to purchase these assets in M1.
3. Good to hear that 10% is as good as anything else.
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MetaPhysician
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by MetaPhysician »

Northern Flicker wrote: Sat Jan 22, 2022 3:14 pm Sector risk is diversifiable and uncompensated. If your goal is to reduce perceived sector concentration risk of market indices, then factor tilts, REIT tilts, and international diversification are the methods used and recommended by professionals.
Could you please explain what you mean by 'uncompensated'?

Yes you are correct that I am trying to reduced sector concentration risk.
000 wrote: Sat Jan 22, 2022 3:24 pm No they don't. I would just sample the space myself buying representative stocks.

I wouldn't rebalance either as it is fairly likely there will be one big winner and a bunch of losers.
Yes that is my intuition as well and some data supports this.

So you're saying put money in the representative assets and let them ride?

Wouldn't I miss out on buying low and selling high and a rebalancing bonus?
Northern Flicker wrote: Sat Jan 22, 2022 5:31 pm
000 wrote: Sat Jan 22, 2022 3:24 pm No they don't. I would just sample the space myself buying representative stocks.

I wouldn't rebalance either as it is fairly likely there will be one big winner and a bunch of losers.
Or just a bunch of losers if sector risk materializes. You may get lucky and pick a winner, but the market does not discount in additional expected return because you chose not to diversify away sector risk and security-specific risk.
Understood. Good point.
vineviz wrote: Sat Jan 22, 2022 6:01 pm
MetaPhysician wrote: Sat Jan 22, 2022 1:33 pm
  • This space is extremely volatile
  • This space is dominated by the top two assets (~80%)
This doesn't sound like a sector where indexing makes any sense. Diversified mutual funds can't have 80% of assets in two stocks, and honestly you could replicate that index for free pretty well just by buying those two stocks plus or two more.

Ultimately it's going to play out more like a stock picking exercise than typical sector tilt, but at just 5% of your portfolio you're likely to lose a relatively small amount of money.
I always held that indexing always make sense but as you stated maybe it doesn't in this particular specific case.

I agree that this is more like a stock picking exercise than a sector tilt.

What happens with time if the sector becomes more diversified such as more percentage in assets 3-7, for example? Would that make you consider an index fund then?
Northern Flicker
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by Northern Flicker »

000 wrote: Sat Jan 22, 2022 5:42 pm
Northern Flicker wrote: Sat Jan 22, 2022 5:31 pm Or just a bunch of losers if sector risk materializes. You may get lucky and pick a winner, but the market does not discount in additional expected return because you chose not to diversify away sector risk and security-specific risk.
I was referring only to relative performance to the sector not to broad market. The OP already told us he wants to tilt to a sector and you already warned him with your thoughts about diversifiable risk.

Question for you: why do you consider REITs a special case? Why factors?
Sector risk is one diversifiable risk. Security-specific risk is another. Implementing a sector tilt by holding individual stocks just increases the level of uncompensated risk.

I don't tilt to REITs but the rationale is that REITs only capture a very small slice of the overall real estate market. In this view, tilting to REITs is not making a sector bet but aligning the portfolio more closely with the broader economy.
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by MetaPhysician »

Northern Flicker wrote: Sun Jan 23, 2022 2:31 pm
000 wrote: Sat Jan 22, 2022 5:42 pm
Northern Flicker wrote: Sat Jan 22, 2022 5:31 pm Or just a bunch of losers if sector risk materializes. You may get lucky and pick a winner, but the market does not discount in additional expected return because you chose not to diversify away sector risk and security-specific risk.
I was referring only to relative performance to the sector not to broad market. The OP already told us he wants to tilt to a sector and you already warned him with your thoughts about diversifiable risk.

Question for you: why do you consider REITs a special case? Why factors?
Sector risk is one diversifiable risk. Security-specific risk is another. Implementing a sector tilt by holding individual stocks just increases the level of uncompensated risk.

I don't tilt to REITs but the rationale is that REITs only capture a very small slice of the overall real estate market. In this view, tilting to REITs is not making a sector bet but aligning the portfolio more closely with the broader economy.
Well said. Thx
000
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Re: Do Low ER Index Funds Exist for Concentrated Small Sectors?

Post by 000 »

MetaPhysician wrote: Sun Jan 23, 2022 12:25 pm Yes that is my intuition as well and some data supports this.

So you're saying put money in the representative assets and let them ride?

Wouldn't I miss out on buying low and selling high and a rebalancing bonus?
Anything's possible but long term equity returns are usually dominated by a very small number of winners. This is true both of the broad market and within specific sectors. It's more likely you'd be breaking the momentum of the one winner to buy more losers.
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