Beware That Diversifying Doesn’t Turn into Tilting

Tilting Spinning TopTilting, when done intentionally, is generally understood to be the act of pursuing an otherwise seemingly passive or lazy investment approach and then loading up on some specific additional investment so that your portfolio is more heavily weighted or biased toward that investment. This is done for the purposes of trying to earn greater return than the purely passive approach might afford you, i.e. you are attempting to outperform the market. For instance, you may buy an S&P index fund as part of your portfolio and then purchase additional shares of Apple separately. You are then tilted toward Apple in particular and technology more generally because your S&P index fund already contains shares of Apple, giving you exposure to the company and its sector. While there is absolutely nothing wrong with purposely tilting as a practice so long as you understand the risks – it’s your business – you must be wary that you not end up inadvertently doing it in your pursuit of passive portfolio diversification. If you never meant to tilt and your real objective was simply passive diversification all along, then you have done yourself a disservice without realizing it by exposing yourself to unnecessary risk. By paying careful attention to a fund’s holdings during fund selection, you can avoid this.

The example given above is a fairly obvious and straightforward one. Things can quickly get more confusing and opaque, though. For example, you may have heard that some professionals recommend holding real-estate-related investments as part of a well-balanced and diversified portfolio. But let’s say you already hold Vanguard’s Total Stock Market Index Fund (VTSMX), which basically encompasses all stocks on the US markets. That should include some real estate investment trusts (REITs), right? Or do you now need to go out and buy shares in Vanguard’s REIT fund (VGSIX)? The answer is both no and maybe – Vanguard’s Total Stock fund has a current weighting of slightly over 4% in real estate as of the posting of this article, according to Morningstar data, and the fund is built to mimic the reality of the US markets with respect to market cap. A purely passive approach would dictate that you do not buy extra real estate shares. However, if you want to approximate the allocation percentages recommended by some experts (10% or higher of your portfolio in real estate), you would have to buy into Vanguard’s (or some other company’s) REIT fund just enough to meet your ultimate desired allocation percentage when combined with what’s already in the Total Stock fund. Of course, no recommendation is being made here about whether you should or shouldn’t, we’re simply reiterating that the Total Stock fund already contains REITs and that if you purchased more real-estate related shares, you would, by the strictest definition, be tilting away from the natural market-cap composition of the equity markets in the US.

As with sector allocations in the above example, you have to be weary of regional allocations when it comes to diversification with international equities and the investment vehicles you have to choose from. Vanguard’s Total International Stock Index Fund (VGTSX) and Total World Stock Index Fund (VTWSX) allocate different amounts to emerging markets, so, depending upon your goals, you may be more or less weighted in emerging market stocks than you wish to be and may have to adjust accordingly with a pure emerging markets investment vehicle to reach your desired allocation percentages.

Things can get yet more difficult to discern. Take the example of two funds offered by TIAA-CREF to their account holders, the TIAA-CREF Large-Cap Growth Index Fund (TILIX) and the TIAA-CREF Large-Cap Value Index Fund (TILVX). Growth and value are two different stock styles and, you would think, mutually exclusive. However, it appears that some stocks, including Johnson & Johnson and Microsoft, share spots on both lists of holdings of each fund. It’s true, each fund holds different amounts of each stock, but suffice to say that you may be getting more of certain stocks than you realize or bargain for.

The only way to avoid incidental tilting is to do your homework – there’s just no getting around that. As always, settle upon your asset allocation percentages first (70/30 stocks/bonds), then decide how those will be broken up into sub-allocations (domestic/international/growth/value). Finally, as you select the actual investment vehicles pay special attention to their portfolio compositions and allocations to different sectors and regions where it comes to the broadest-based equity funds, and to individual stocks where it comes to more narrowly-focused stock index funds such as the growth and value types. As with everything else, this exercise will become easier with practice as you peel back the layers and familiarize yourself with the different funds available out there.

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