ITA Wealth Management

I’ve participated in a few discussions as to whether it is better to diversify the portfolio by using Sectors or Asset Classes.  It has always been my contention that spreading ones wealth over numerous asset classes is preferable to using sectors.  This morning I set up a portfolio built around ten sectors.  Here are the ETFs I used in this portfolio.

• IYK
• IYC
• IYE
• IYF
• IYH
• IYJ
• IYM
• IYW
• IYZ
• IDU

In each of the 10 iShares, an investment of 10% was allocated.  The test was to check the projected annual return, SD, Portfolio Autocorrelation, and Diversification Metric and compare them with the same metrics from a portfolio built around asset allocation.  It is not even a contest.

1) The projected return for ETFs using asset allocation is nearly 2% better when compared with sector diversification.
2) The standard deviation is more than double if one goes the sector route.
3) The Portfolio Autocorrelation is almost four times as high with sectors.  This is “Red Flag” country.
4) The Diversification Metric is about 1/3 with sectors.  That does not surprise me as that has been my argument against diversifying via sectors for a long time.  This only provides data for something I thought to be true.

To improve the sector diversification, I added an international ETF as well as an emerging market ETF.  The results did not change significantly.  In fact they got a little worse in three of the four metrics.

Until there is compelling evidence, I plan to stick with diversification via asset classes and let others use sectors.

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Lowell Herr

Photograph: Weaver in China