The world of investment can be a strange place sometimes. Recently, when I was analysing a particular fund, I was reminded of this reality. There’s a weird thing that all fund managers do, by industry convention, that can really mess up decision making for the unsuspecting investor. Make sure you don’t get caught out.
As I’m sure you know, one of the most crucial and basic principles of successful investment is that you should spread your money around. This is known as diversification. It prevents you getting wiped out if any individual investment goes bad.
Also, any serious investment strategy will include a big allocation to stock markets. Exactly how big will depend on market conditions, but stocks – especially cheap ones – should always be a feature.
That’s because, in the long run and if approached correctly, this asset class is one of the best performers out there – if not the best. But the stock market investments themselves still need to be spread around as well, to reduce risks still further.
You can divide them in at least three different ways. These ways overlap, but the aim is that your overall stock portfolio isn’t too concentrated under any individual category.
The first of these is by company size, or “market capitalisation”. The idea is to have a range of stocks from the huge “mega caps”, with values in the hundreds of billions, down to the tiny “micro caps”, with values in the tens of millions. There’s likely to be more concentration at the top end and less at the bottom, but there should still be a range of sizes.
The second way is by geography, which looks at where companies are based and where they do most of their business, which are not always the same thing. The idea is to have a portfolio of shares in companies that operate in a wide range of countries.
The third way is where we’ll get into the weird little oddity that all stock investors should know about. This is diversification by industry sector, meaning the types of business that the companies are engaged in.
Financial industry standards and conventions split companies into 10 different sector categories. These are: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Healthcare, Financials, Information Technology, Telecommunication Services and Utilities.
By and large these classifications are pretty intuitive. Oil & gas companies are a big part of the energy sector, miners fit into materials, food and drink comes under consumer staples, power companies are utilities, and so on. It would take too long to describe all of these in detail, but if you’re interested you can find full explanations here.
But it’s in the largest sector of all where it’s easy to get misled. That sector is the “Financials”. This grouping makes up nearly 22% of the MSCI ACWI IMI, which is an index that (it is claimed) includes 99% of all investable stocks in the world. (The full name is the unwieldy MSCI All Countries World Index Investable Market Index. Two “indexes” for the price of one!)
Clearly we need to understand what goes into the “Financials” sector bucket. It’s over a fifth of world stock markets.
You probably think that it’s pretty obvious. “Financials” are mainly going to be banks, right? Then think a bit harder and you’d probably add insurance companies, investment banks, non-bank lenders, stockbrokers and fund management companies. And you’d be correct to include them all.
Now take a look at this chart of the sector split of a particular ETF that I was analysing recently. I won’t name the ETF, as I just want you to concentrate on the sector split.
One glance at this chart and you’d be forgiven for thinking that the fund is dominated by investments in banks. After all, over 44% is concentrated in the financials sector.
But you’d be wildly wrong with that assumption. In fact banks make up less than 4% of the fund – under one tenth of the total investment in financials.
There’s a really simple reason for this, but very few investors are aware of it. It’s one of those important but neglected details that gets buried in the collective fine print of the financial industry.
“REITs” are real estate investment trusts, which are tax efficient vehicles for investing in property that are permitted in certain countries.
Bizarrely, the “financials” sector also includes “real estate companies and REITs”, according to MSCI’s own definition. “REITs” are real estate investment trusts, which are tax efficient vehicles for investing in property that are permitted in certain countries. “Real estate companies” include other owners of land and buildings, construction and development companies, and other companies operating in the real estate sector.
This is where the problem lies. For the most part the financials sector is dominated by what you’d expect: big banks and insurance companies.
But sometimes, in some funds and ETFs, it can be dominated by the real estate sector. It depends on how the fund manager has constructed the fund, or perhaps on the country index that the fund is tracking.
This is important because it affects investor decisions on whether to buy a particular fund or not. Now take a look at this next chart.
Looking at this we get a very different impression. Nearly 31% of the fund is invested in the real estate sector, 9% in insurance and 4% in banks. But, as you’ve probably spotted, this is exactly the same fund as before. It’s just represented in a different way.
…fund managers usually do a bad job of highlighting whether the financials sector is concentrated in real estate companies or not.
Unfortunately fund managers usually do a bad job of highlighting whether the financials sector is concentrated in real estate companies or not. In this case I had to comb through the full list of 50 individual stock investments and separate out which of the financials were real estate, which were insurance and which were banks (just one as it turned out).
For funds spread across hundreds of stocks – and there are many – that would be a really laborious process. Some fund managers don’t even disclose more than the top 10 holdings, making it impossible.
This issue is important because it could lead you to make incorrect investment decisions. Without further investigation you could assume a fund has a heavy weighting to banks and not realise it has a large exposure to real estate instead. I’ve come across this issue many times, and in many funds, so it’s certainly something to watch out for.
Perhaps you already have a lot of investments in real estate that you don’t want to add to, but you do want to increase exposure to banks. In that case, buying this fund would increase your concentration in real estate even more, which could be highly risky, and add very little to your bank investments.
On the other hand, perhaps you want to avoid extra exposure to bank stocks but are happy to add more real estate since you own little of this sector. Without a bit of digging you could mistakenly reject the fund and miss an opportunity.
Either way it would be a mistake.
It’s bizarre that real estate gets lumped into the huge financial sector, which is already a diverse mish-mash of different types of money shuffler. I’ve never understood why it can’t be a sector of its own.
But it is what it is, and I don’t expect the index providers or the fund management industry to change the way they do things any time soon.
So this is a weird thing that all fund investors should know about. It’s a detail, but an important one. Not least because financials make up the biggest sector in world stock markets.
If you’re interested in investing in a fund or ETF that has a large allocation to financials, make sure you take a closer look to work out how much of that is really real estate. Don’t get caught out.
Stay tuned OfWealthers,