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In Search of Profit: Diversify or Concentrate?

By Lawrence Czelusta (from the December 2005 issue of Index Rx)

Q: Doesn't this trade (sell EPP, buy VWO) duplicate EEM? Are we now to have two-thirds of our money in emerging markets? Doesn't this reduce our diversification?

A: We'll take this question in two parts. First, regarding duplication, or concentration in similar segments:

As a rule, Index Rx does not purchase two funds in the same portfolio if they track the same index. However, VWO does not duplicate EEM. This is the reason that you will occasionally notice fairly substantial divergence in the daily performance of these two funds. For example, on December 6th, EEM gained 0.92%. On that same day, VWO gained 1.24%. The next day, EEM was down 0.95%, while VWO's relative strength continued, with the fund falling only 0.65%.

These variations in performance are due to differences in the underlying indices followed by these funds. Although parts of VWO do follow the MSCI Emerging Markets Index (EEM's target index), Vanguard's Select Emerging Markets Free Index (tracked by VWO) differs from the MSCI index in important respects. In addition to variation in holdings within countries, VWO excludes Columbia, Egypt, Jordan, Malaysia, Morocco, Pakistan, Russia, Sri Lanka and Venezuela because of concerns about liquidity, repatriation of capital, or entry barriers in these markets, . This does not necessarily make VWO a better fund than EEM. These excluded countries may be the top performers in EEM in coming months.

The point is that we do not have to be concerned about any of this. Performance is what matters with Dynamic Indexing. We will hold or sell for one reason: mid-term relative strength. If they perform, we keep them. If they falter relative to other funds, we sell. We do not concern ourselves with event-based prediction, which falls in the established province of gurus and seers and is also known as "the paralysis of fundamental analyses." It's sort of like this: the sun comes up in the East. A guru will ask: "Why does it come up in the East instead of the West?" He'll then consult his college textbooks, talk to stock analysts, turn on CNBC, and, if he still doesn't have an answer, he'll "ask Chuck" (who will charge him an exorbitant fee for the non-service). Meanwhile, Index Rx investors will simply look to the East each morning, having spotted the pattern.

A major philosophy of Index Rx is to concentrate investments in segments of the stock market that have been rising the most over the mid term. Research (and our recorded performance) have shown this to be a winning long term strategy.

For instance, in a 1994 article in The Journal of Professional Management, Roger Ibbotson and William Goetzmann published an article entitled, "Do Winners Repeat?" This article was written in part to determine if funds that had performed better over past periods (from one month to two years in length) exhibited predictably superior performance in later periods.

Ibbotson's and Goetzmann's analysis indicated that investing in winners slightly increased the chance of outperforming the average return for all funds in the subsequent period. (William N. Goetzmann and Roger G. Ibbotson, "Do Winners Repeat?", The Journal of Professional Management, Winter 1994, pp. 9-17.)

However, Ibbotson and Goetzmann said that picking winners, based on performance relative to their peers, may not be enough to beat the market (Wilshire 5000). They concluded: "While the 'repeat winner pattern' may not be a guide to beating the market, it does appear to be a guide to beating the pack (non-index funds) over the long term."

With respect to this conclusion, John Bogle stated, "In the face of index fund competition, then, to what avail is a strategy that relies on evidence suggesting a tenuous persistence of a fund's performance relative to its peers, when unaccompanied by any evidence- in fact, with considerable evidence to the contrary- of persistence that outpaces the market?"

Exactly, Mr. Bogle. With this study's seed of hope for better performance, Index Rx has taken the idea of repeat winners or relative strength (with significant modification) and applied it to index funds and ETF's. In this way, our 'peers' become the market indexes instead of actively managed funds (which, over the long term, under-perform the market as a whole). This philosophy has been a major reason that we have been able to outperform the market in the past, and should continue to do so in the future.

To the second, related part of the question (reduced diversification): Yes, this trade does reduce our diversification and therefore does increase risk slightly. But keep in mind our goal: to beat the Total Stock Market over the long term by as much as possible, with less relative risk. The only way we can do this is to concentrate our investments in top performing market segments, while taking advantage of the automatic diversification provided by index funds. Keep in mind that even if you were to purchase just one emerging markets index fund, your portfolio would be more diversified than that of the average investor in individual US stocks. By holding three (or more) index funds, we have historically been able to limit the risk levels of our portfolios (according to standard measures), even though these funds overlap from time to time.

If diversification remains a concern to you, you do not have to follow only one portfolio. Because Index Rx is seamless in the sense that we invest only in index funds (including ETFs), it is very easy to mix and match. Some investors (usually those with larger portfolios) invest in all of the components of all of our portfolios. Currently our portfolios are holding eleven different ETF's/mutual funds. Such a strategy certainly increases diversification. The Hulbert Financial Digest uses the average of all of our portfolios to determine our performance. Nearly anyone can duplicate this average performance. To invest in all of our funds, it costs only $7 for an ETF market trade of any amount, and many of our mutual funds are no transaction fee funds. Over the long term, we believe all of our portfolios will beat the market, as have High Dose Rx, Max Dose Rx and ETF Rx to date. That is why many financial planners and investment advisors subscribe to Index Rx. Isn't it nice to know you can do as well as they do as an independent investor?



©2007 Index Rx Inc.