Large Cap Stock Diversification (Video)

Video On the Topic, followed by a Blog Discussion Below:


On this blog/video we talk about large cap stocks which are stocks of companies with a large market capitalization (the cap in large cap). We say that a stock is a large-cap stock when the total value of all of the company’s shares outstanding, meaning the shares held by all shareholders, including company insiders, is greater than $10 billion.  Some examples of large cap companies include:

  • Apple (AAPL)
  • Microsoft (MSFT)
  • Berkshire Hathaway (BRK.A)
  • Visa (V)
  • Johnson & Johnson (JNJ)
  • Walmart (WMT)
  • Mastercard (MA

Large cap stocks represent the majority of the U.S. equity market, they are often looked to as core portfolio investments. These companies tend to be well established companies who are transparent in their disclosures and can often move the market because of their size.

To be well diversified, we recommend being invested in varying market caps and approaches including small and mid-cap which we will talk about in another blog/video.  And then still this is just in the domestic market and does not include the other market diversifying exposure we use to reduce risk and volatility.

But today we are focused on large cap exposure in your portfolio where we are currently using 6 different funds/etfs having different objectives, creating further diversification.  We have evaluated the correlations of each of these funds to each other and the underlying securities to ensure we are achieving true diversification.  In other words, each fund has a purpose and adds to the Risk/Return profile of your portfolio.   Even without knowing how they are different, you can see in the chart below that they all performed very differently in 2020, the last quarter of 2020 and even the last 5 years.

The Role of Each Fund

SPDR S&P 500 ETF TRUST (SPY)

The SPDR S&P 500 trust is an exchange-traded fund designed to track the S&P 500 stock.  The weight of a company in the index is equal to the market cap of that company divided by the total market cap of all the companies in the index. For example, by the end of 2020, the largest constituent of the S&P 500 index was Apple (Nasdaq: AAPL) with a weight of 6.7% of the total index. Overall the top ten companies in the S&P 500 index comprised more than 25% of the index over the past year.

INVESCO S&P 500 EQUAL WEIGHT (RSP)

With an equal-weight ETF, you hold all the stocks of the S&P500 but in equal amounts, regardless of the size of the company or sector.  Although both indexes (SPY and RSP) are comprised of the same stocks, the different weighting schemes result in two indexes with different properties and different benefits for investors.  With SPY you hold much more telecommunication and Information Technology stocks and with RSP you hold more industrials, Materials and Utilities.  Over the long run, RSP has outperformed SPY but over the past 5 years it was the reverse.

 INVESCO S&P 500 REVENUE ETF (RWL)

With an revenue-weight ETF, you hold all the stocks of the S&P500 but allocations are determined by top line sales and will tend to overweight stocks with thin profit margins and higher debt-to-equity ratios where companies are using higher leverage which can result in strong performances in bull markets.

SPDR S&P DIVIDEND ETF (SDY)

This etf seeks to replicate the performance of the S&P High Yield Dividend Aristocrats Index which consists of the 50 highest dividend yielding stocks in the S&P which have increased dividends every year for at least 25 years. These stocks have both capital growth and dividend income characteristics, as opposed to stocks that are pure yield, or pure capital oriented. Over the past 5 years SDY has a return and has a higher expense ratio but during volatile markets the higher dividend will create a smoother return.

DOUBLELINE SHL ENH CAPE-I (DSEEX)

This is a managed fund, but the expense ratio is lower since it is an institutional share where we pay no marketing, no sales load, no 12b-1 fees and bypass the minimum requirement (institutional shares will be discussed in another blog/video).  The fund uses derivatives to earn excess return above the S&P.   The fund aims to identify undervalued sectors based on a modified CAPE Ratio developed by Shiller and also uses a momentum factor to mitigate value traps.  This strategy is relatively sophisticated and over the past 5 years has performed better than the S&P net of the expense ratio.

STONE RIDGE US HDG EQTY-I (VRLIX)

Another sophisticated strategy using options such as put writing, covered call writing, option spread, options-based hedged equity, and collar strategies. In addition, option writing funds the fund may seek to generate a portion of their returns, either indirectly or directly, from the volatility risk premium associated with options trading strategies.  This fund is intended to behave differently than the rest of the other funds and is the most negatively correlated holding.  Recently it has underperformed, and the fund is on our watch list.  We have spoken to the fund manager and we still believe their approach could provide some downside protection to our portfolios, but we are limiting our holding for the time being.

In Summary

The choice of weighting methodology and investment approaches are very important decisions that have the potential to impact the risk/return profile of your portfolio. Ultimately, there is no universally superior methodology that holds the secret to lower risk and excess returns in the large cap asset class. Certain choices will perform well in certain environments.   Understanding our philosophy in the importance of diversification should help explain why we hold all of these funds.

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