Is A Narrow Based Portfolio Right For You?

A deep dive on how to build a portfolio at the sector level along with common mistakes to avoid.

The picture accompanying this post is an engine panel from a fire truck. There's obviously a lot of moving parts and all of those parts perform a vital function. It is similar with a narrow based portfolio, each holding performs an important function and usually multiple functions. This contrasts with broad based portfolios which might consist of the SPDR S&P 500 (SPY), iShares Core S&P Small Cap ETF (IJR) and iShares MSCI EAFE ETF (EFA). We touched on some of the drawbacks of using solely broad based funds the other day and this post is a follow up on how to build narrow based portfolio.

To be clear, using broad based index funds is perfectly valid and will get the job done in conjunction with an adequate savings rate, proper asset allocation and the avoidance of self-destructive behaviors. I prefer a narrow based portfolio to better manage volatility, perhaps generate a little more yield, it makes it easier to overweight and underweight parts of the market based on either market conditions or specific client issues, hopefully generate a better long term return and more importantly, hopefully a better long term, risk adjusted return.

Seeking a better return is not really about trying to outperform every year, no one will realistically do that. A typical investor will have year they are ahead and years they are behind, the key to long term success is staying close either way combined with what I said above; having an adequate savings rate, proper asset allocation and the avoidance of self-destructive behaviors.

I think of a narrow based portfolio as including individual stocks, sector funds, industry funds, country funds and thematic funds. Carrying it out a little further various types of alternative strategies also fit into narrow based.

The above linked post is about whether or not the tech sector has grown into a risky weighting in the S&P 500 so I will use the tech sector for this post as an example for my approach to narrow based portfolios. I build portfolios at the sector level, deciding whether to be overweight or underweight the sectors based on top down factors like where we are in the cycle, macro trends helping or hurting the sectors and each sector's current weight versus its historical weighting. I've blogged countless times about a sector growing north of 20% of the index as being a flashing yellow light and 30% being a flashing red light.

Tech currently comprises 24% of the S&P 500. Being overweight (that is allocating more than 24% to tech) is putting an awful lot into the one sector. Let's assume an investor wants a little less exposure, like maybe 20%. That would not be a big bet but could reduce volatility versus the benchmark a little bit and make the portfolio a little less vulnerable to the idea that the S&P 500 is a tech momentum fund (an idea explored in the above linked blog post).

Of course you could use all individual stocks to build the sector (and the entire portfolio for that matter) but to the extent you may not have the time to become an expert in 35 or 40 stocks or have the time to monitor 35-40 stocks, ETFs can relieve some of that burden as well as mitigate the consequence of being wrong. To be clear, I think there is still plenty of work monitoring narrow based ETFs and someone not interested in putting in the time may not want to use narrow based products.

With tech being such a big sector, I think of it almost as a core and satellite positioning with the core being one the several relatively broad based tech sector funds like the Vanguard Information Technology (VGT). How much you put in a core position, I prefer the word anchor, is subjective but for this example let's say 10%. That leaves another 10% for narrower exposures.

Israel is a tech heavy investment destination with the sector weighing in at 27% in the iShares MSCI Israel ETF (EIS) and the sector in Israel captures some interesting niches in tech including fintech and cyber security. An investor wanting to capitalize on Israeli innovation and accelerating GDP growth could, instead of looking at EIS could consider of the two two Israel-tech sector ETFs. The bigger of the two is the Bluestar TA BIGI Tech Israel Technology ETF (ITEQ) along with the ARK Israel Innovative Technology ETF (IZRL). There are some big differences between the two. IZRL has 20% in healthcare compared to just under 9% for healthcare in ITEQ.

Someone with any interest here would need to look more closely at the holdings to see whether either of the funds would work as a proxy for Israel (we're assuming someone wants that exposure) and as a proxy for tech. It certainly is possible it could be a proxy for both which is I was talking about in the intro about narrow based holdings serving multiple functions in a portfolio. There are other country funds that could reasonably serve as tech proxies like iShares MSCI Taiwan (EWT) which is 57% in tech and there are thematic, country funds like KraneSahres CSI China Internet ETF (KWEB) which is 90% in technology.

There are of course plenty of thematic tech funds (non-country specific) covering slightly broader spaces like internet generically (FDN and XWEB as examples), semiconductors (SOXX and SMH) and other bigger ones. There are narrower niche funds too like ETFMG Prime Mobile Pay (IPAY), Global X Social Media (SOCL), and First Trust NASDAQ Cybersecurity ETF (CIBR) and plenty of others. Obviously someone will break the seal on a blockchain ETF. If you actively engage in markets then you've probably scouted out some of these themes and learned at least a little about them.

Part of the equation using narrower ETFs combined with larger ETFs like VGT is the risk of ending up with much more exposure to individual stocks than intended. VGT has a 6.6% weighting to Facebook (FB). A 10% weighting in VGT means a 0.6% weighting in Facebook, likely not a problem. SOCL had about 10% in FB so a 5% weighting in that fund combined with the VGT exposure get the portfolio to 1.1% total in FB. FDN has 8% in Facebook so a 5% weighting in FDN combined with the other two results in about 1.5% in FB. I don't think 1.5% in the name is a crazy risk but the point is it adds up and anyone going this route needs to look through to the holdings (there is software for this or you can do it manually) and make sure you don't end up with six funds all owning some stock leaving you oblivious to what turns out to be a meaningful exposure.

The final piece is using individual stocks as part of your sector allocation. If all the funds you own get you to a 4% weighting in some mega cap stock then you may not want to be yet more shares of it as an individual issue but if you do, just be aware of the total exposure.

When it comes time to take defensive action, as I mentioned a couple of weeks ago, the way things are looking it is very plausible that tech will be ground zero for the next bear market. Selling the core position (VGT in the example we're working with for this post) and replacing some or all of it with some sort of inverse fund pretty seriously changes the extent to which the portfolio looks like the market with just two trades. A fully implemented defensive strategy would involve more than two trades but it is a good start.

One last point is all of the names mentioned in this post are just examples, I don't own any of the tickers personally or for clients but this is how I access tech, a core fund combined with individual names and narrow funds.

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