One of our issues with passive investing today (i.e., using a formula-driven index to determine what to own and how much to own) is the lack of diversification. Diversification only works if the assets that make up the portfolio respond to different economic drivers in different ways. A better term for real diversification might be contingent investing.
What do we mean? From Horizon Kinetics’ (HK) 3Q2023 report(1), let’s look at the iShares MSCI All Country World Index ETF (ACWI), which is constructed based on an index of global stocks:
Energy makes up 5% of the index
Materials makes up 4.3%
Information Technology makes up 26%
The S&P 500 index is like ACWI but with more risk:
Energy is only 3.4% of the index
Materials is only 2.4% of the index
Information Technology is 39.6% (“including Alphabet and Meta Platforms, and 42.9% if including Amazon too”)
In other words, contingent investing no longer exists in the major indexes. Index investors are not getting the diversification they think they are – especially given the monetary and commodity related inflation risks ahead.
“How does one prepare for events that haven’t and might not happen, yet will cost dearly if and when they do? Something broadly systemic, like severe monetary inflation or something more narrowly systemic, like a wave of technology displacement that would wreak havoc on the mainstream indexes? The confidence level might be low, but the impact would be high. It requires a different approach than standard economic and market modeling, which typically attempt to forecast the development of events that are already known and much discussed and with presumed confidence.”(2)
If you believe the years ahead will look like the last 15 years, then you should own the S&P 500 index. If you believe the years ahead will look very different, then you should seek some measure of diversification away from U.S. large cap growth stocks. We think there are very plausible reasons why the last few decades were the anomaly and not the rule. The way to prepare for that – if you haven’t already – is to persist with meaningful allocations to (a) quality businesses outside the U.S. and (b) hard assets (i.e., businesses linked to energy and materials).
2. Ibid