Question: ACWV has only 295 holdings. How can this be a truly global, highly diversified fund? Thanks.
Answer: I like the way you think. The greatest danger in equity investing is inadequate diversification, and I’d much rather someone be overdiversified than underdiversified. I’m also not going to fight to the death on this one, since ACWV (MSCI All Country World Minimum Volatility ETF) is merely my favorite all-in-one fund at the moment and not my theoretical ideal.
That said, I consider an equity portfolio well-diversified as long as it isn’t overly dependent on the performance of a single security, industry, or country. I don’t even think it takes 295 stocks: IOO (iShares Global 100 ETF) has a 95% correlation to VT (Vanguard Total World Stock Index ETF) with its nearly 5,000 holdings, and the two have virtually identical volatility and total returns.
Moreover, alternative weight index funds such as ACWV don’t need to hold as many securities as the traditional market weight index funds, since the former strategy limits overconcentration in a small number of stocks. The largest holding in ACWV is under 2%, and industry diversification is comparable to ACWI (MSCI All Country World Index ETF). I will admit that I’d prefer more European exposure in ACWV, but I’d also prefer more Asian exposure in ACWI. And I’d prefer lower U.S. exposure in both. ACWV just happens to be my favorite all-in-one fund at the moment, but I don’t use it very much with clients (except for smaller holdings) because I’ve got the time, motivation, and professional discipline to be more thorough in diversifying their portfolios geographically through multiple funds and to actively manage individual stock portfolios to gain tax advantages through loss harvesting that index funds cannot provide. But this blog is mainly intended for DIY investors.
I don’t agree with those who have made a different diversification case against funds such as ACWV based on “tracking error,” where they define the market-weighted index as the ideal and point out that alternative weights result in annual performance differences that can be significant and long-lasting. After all, one reason I prefer alternative weighting is that I HOPE to have performance that is, over the years, better than the traditional indexes, which means it will have tracking error. If an investment has better returns and lower volatility than the index it is being compared to, am I supposed to consider that a bad thing? This is why I don’t benchmark the portfolios of my clients: I’m looking for good risk-adjusted returns over time on an absolute basis and not relative to a particular index.
And in the case of ACWV, its mean-variance optimization approach means selecting securities with low historical correlations to each other, so that there should be more zigging of some when there is zagging of others, and it should be expected to result in lower highs and higher lows than a traditional index. Even if the final results end up not being superior, most long-term investors would, all other things being equal, prefer a smoother ride. I consider it, on the whole, better diversified than VT and ACWI because of the lower volatility resulting from its use of correlation.
If you prefer the Vanguard Total World Stock Index with its 4,859 securities weighted by market capitalization, I am absolutely fine with that. I am not certain that the superior performance of alternative indexing to date will continue into the future. But I also think any portfolio that limits its holding in a single security to under 2% and its holding in a single industry to under 5% is diversified enough to prevent a really bad outcome and as likely as a total market fund to produce a good one.