Advantages of directly owning 30 or more stocks instead of an index fund

By quantofasiaInvesting

This is an summary and excerpt of my article “Why I Wouldn’t Invest More Than $100,000 In An S&P 500 ETF Or Index Fund“.

Ask 100 fee-only financial advisors how they would invest an extra $100,000 that was not needed for at least 10 years, and odds are that one of the top responses would be to simply buy and hold a low-cost, broadly diversified index fund or ETF.

This article makes no attempt to debate whether to invest in active vs. passive funds, nor whether the S&P 500 is the right or best index to use as a benchmark vs. any other index. Rather, I explain below how an investor may decide to track an index like the S&P 500 through a passive portfolio of direct stock positions instead of through an index fund or exchange traded fund (ETF).

How To Track The S&P 500 As Completely As Possible

The Standard & Poor’s 500 index remains one of the most, if not the most, liquid and widely used investment benchmarks in the world. Ask 100 traders how they would invest US$1 billion in “the market” as quickly as possible, odds are that the top answers would include buying either S&P 500 futures or an S&P 500 ETF. The SPDR (Standard & Poor’s Depository Receipt) S&P 500 ETF (NYSEARCA:SPY) is the oldest (founded 1993) and still by far the most liquid S&P 500 ETF, but is no longer the largest ETF, or even the largest S&P 500 ETF, having been surpassed in size by the lower-cost Vanguard S&P 500 ETF (NYSEARCA:VOO), whose management company pioneered low-cost S&P 500 index funds with the Vanguard 500 Index Fund (MUTF:VFINX) back in 1976.

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How To Track The S&P 500 “Closely Enough”

For an investor with $100,000 to invest, it would not make sense to buy shares in all 500+ stocks in the S&P 500, but it is not difficult to track the index “closely enough” with a smaller number of securities. Alongside the questions of how actively or passively a stock portfolio should be managed are the debates on how many stocks are needed to provide enough diversification for an investor.

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Perhaps the most “obvious” strategy for tracking the S&P 500 is to simply buy and hold the top 10 stocks in the S&P 500. Historically, these top 10 names have represented 10-20% of the market cap of the entire index, but tracked over 80-90% of the up and down moves of the index. Backtesting the current top 10 names over the past year shows the syncing of these daily fluctuations while the basket of 10 outperformed the index by over 10%, but this can be easily explained by the hindsight bias of including the high-performance FANG components Facebook (NASDAQ:FB) and Amazon (NASDAQ:AMZN) as they entered the S&P top 10.
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Fortunately, an easy-to-track portfolio of 30 stocks, called the Dow Jones Industrial Average (DJIA or “The Dow”), has been widely followed for over 100 years, and this portfolio has an amazingly good record of tracking the S&P 500. The Dow is not only far narrower than the S&P with only 30 names, but has different names that do not completely overlap with the S&P top 30, and it weights those names by price instead of by market capitalization. Price weighting has the often criticized features of giving 3M Company (NYSE:MMM) 6x the weighting of the 2.5x larger General Electric Company (NYSE:GE), and allowing these weightings to be changed by stock splits, but price weighting brings the huge advantage of making it far easier to track an index exactly with a smaller portfolios. Surprisingly, this difference in breadth and weighting has resulted in little difference in long-term total returns over the past 55 years:
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As I mention in one of my other articles “Why Dow 20,000 Does Matter For U.S. Blue Chips And Price-Weighted Indices“, the long respected Dow Jones Industrial Average has a great advantage of being a simple price-weighted index, which with its current divisor means that a simple portfolio of 7 shares of each of the Dow 30 stocks would cost around $20,000, and track the widely published value of not just the Dow, but closely track other indices like the S&P 500.
Globally, we are interested in helping clients make the most out of their global investments wherever possible, which can involve low cost index funds and ETFs when appropriate, but in many cases we replace these ETFs with direct positions in what we believe are the finest and best valued companies in each respective market,
Tariq Dennison is a Hong Kong based CERTIFIED FINANCIAL PLANNERCM Professional and portfolio manager at GFM Asset Management LLC (www.gfmasset.com). GFM is a Hong Kong based asset manager and US registered investment adviser.

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