Ditto Barry, Ditto.
Original Message:
Sent: 03-21-2024 14:14
From: BARRY JOHNSON
Subject: Exploring the Impact of Small-Cap Funds on Portfolio Diversification
As Goober used to say to Andy, "Hey back at you, "Jenna
#1 I have strong opinions on this topic because my preferred investment vehicle of choice is ETFs.
#2 I welcome more experienced AAII member comments to school me in the errors of my conceits. When it comes to learning how to manage money, I need all the help I can get. If markets were an ocean, I start drowning 50 feet from shore and have no hope of getting back to firm land without lifeguards or a boat.
#3 Jenna, I commend your Alice-like "Adventure into Diversification-land." A willingness to learn is the key characteristic that distinguishes growth from decay. Like Red said 30 years ago in "Shawshank," "Get busy living or ... get busy dying." The same applies to investing.
#4 I have previously shared my journey "in search of the perfect diversified portfolio" in a prior blog. I may copy it here since it is pertinent to the topic and I need to update my progress.
#5 I also recommend reading the book "In Pursuit of the Perfect Portfolio" by Andrew Lo and Stephen Foerster (2021). It traces the journey of how the concept of a diversified portfolio was born in 1952 and how it was refined to become the industry standard for investing "perfection" about 25 years later. This book's message also keeps us humble by reminding us that THE perfect portfolio is an impossible dream. ( Thank you, Pancho Sanza. Broadway 1965, Movie 1972. It's hard not to sing right now.) THE perfect portfolio is an impossible dream because you have to build it in the present to address an unknown, uncertain, and constantly evolving set of future states where it will vary in efficacy with the permutations of the very factors you are trying to maximize.
#6 Jeana, I read Cynthia's article over the weekend. Although it covers most of the basics. I find it lacking because it does not provide enough details on how to implement the "simple" "Small-Cap Stock Fund Investing Checklist" that closes this article
#7 This idea should have been expanded to provide specifics on how to implement this very important advice. Motherly advice to "Eat your veggies" is rarely successful if you are served SpaghettiOs.
#9 For example, "management risk" and "level of exposure" are not defined and discussed and no measures for either are provided. The other 3, "level of exposure," "style drift," and "turnover" get a few more mentions in the text (5 times each). These important factors are only presented as characteristics, without an explanation of how someone can recognize them when they see it, and how to deal with them after you understand their significance to your ability to achieve meaningful diversification.
#10 Remember, "The greatest trick the devil ever played was convincing the world that he did not exist" as the quote from the movie "The Usual Suspects" (1995).
#11 The devil in investing is risk. Risks exist. You can debate what is and what is not risk, but the Devil Risk exits. If you want higher returns, you have to dance with the devil and take on added risk. That's the iron law of investing. Diversification is all about how to take on addition risks to achieve a level of return that you can accept.
#12 Jenna, Cynthia, Charles & Associates dba AAII, this article begs for a more detailed follow-up companion article on EACH of the 5 factors described as "a simple checklist you can use."
#13 As one example, I would like to know the details on "management risk." I see this recommendation before many times. What we need is a process for AAII members who what to "do" their due diligence on "management risk" (and the other 4 factors listed.).
#14 "Management risk" is THE nexus where the portfolio manager's plan and his/her abilities to execute meet. Every ETF I have ever bought provides a statement of "Fund Strategy" and every broker advises investors to read it.
#15 Here is an example. This is the stated Fund Strategy for Vanguard Russell 1000 Growth ETF (Ticker VONG.) "The investment seeks to track the performance of the Russell 1000® Growth Index. The index is designed to measure the performance of large-capitalization growth stocks in the United States. The Advisor attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index. The fund may become non-diversified, as defined under the Investment Company Act of 1940, solely as a result of a change in relative market capitalization or index weighting of one or more constituents of the index." OK. I have underlined a few of the follow-up questions I have about how well "The Advisor" nee Fund Manager/Team delivered on his/her/their job. This is where metrics come in handy. EVERY Fund Manager misses this goal by some degree. I just do not buy in on the explanation provided -- "solely as a result of a change in relative" … "market capitalization or index weighting of one or more constituents of the index." I am willing to bet "dollars to donuts" that some of this variance (which is the precise form of risk we are asking about here) was WELL within the Fund Manager's/Team's ability to plan for, measure, and take corrective actions which are within the Fund Manager/Team's annual performance review that drives their compensation.
#16 When I do my home-schooled version of DD, I look for details on management experience (education, certifications), tenure, and turnover. Then I seek data on the measures of fund management performance deployed, like tracking error. Then I want to see current metrics for the components that drive tracking error like … beta, alpha, R-square, Sharpe ratio, and Upside/Downside Capture Ratios.
#17 When It comes to SEC and FINRA-certified "professional" money managers, I am very Ole School. I am a Jack Welch "Rank 'em and Yank 'em." type.
#18 Accountability to investors is a place where accountability matters. Fuzzy, polite, professional tolerances on fuzzy language is not acceptable. That's why I am an AAII Lifer. I expect AAII articles to arm me Chicago style – I want a bring a gun to this knife fight.
Other than these few, I have no opinions on this topic.
------------------------------
BARRY JOHNSON
Original Message:
Sent: 03-20-2024 11:08
From: Jenna Brashear
Subject: Exploring the Impact of Small-Cap Funds on Portfolio Diversification
Hey Small-Cap Investing Community,
I recently delved into an enlightening piece, "Gaining Small-Cap Exposure Via Mutual Funds and ETFs" written by Cynthia McLaughlin, discussing the pivotal role of small-cap mutual funds and ETFs in enriching our domestic stock portfolios through diversification. It underscored the unique benefits small-cap exposure brings, notably in potentially enhancing returns while balancing overall portfolio risk.
This got me pondering about our own experiences and strategies within this vibrant community. Specifically, I'm curious about how each of you integrates small-cap funds into your investment mix.
- How central are small-cap funds to your diversification strategy?
- Have you noticed a significant impact on your portfolio's performance and risk profile since incorporating small-cap exposure?
As a newcomer to investing, I've started incorporating small-cap stocks and ETFs into my portfolio, primarily starting around 2021 and then adding more at the end of 2023. While they're not the core of my strategy, I've focused on selecting a diverse mix of fund sizes. So far, there hasn't been a dramatic change in my portfolio's performance, but I believe this move positions me well for future market fluctuations. The addition of small-caps gives me a sense of security, suggesting my investments might be more resilient if mid or large-cap sectors face downturns.
Looking forward to your stories, strategies, and any advice you have on navigating the small-cap landscape!
------------------------------
Jenna Brashear
AAII Community Manager
Chicago, IL
------------------------------