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Diversifier beware of the unconscious tilt

Don’t take on even more of that which you are attempting to diversify away in the first place…

When done intentionally, tilting is generally understood to be the act of loading up on a particular investment in the pursuit of additional excess return as part of an otherwise lazy or passive approach to assembling a portfolio, such that your portfolio is more biased towards that investment. In doing so, you assume more risk than the purely lazy portfolio presents. Since this is done for the purposes of trying to earn greater return than the purely passive approach might afford you, it would be said that you are attempting to outperform the market.

As an example, you may buy an S&P index fund as part of your portfolio and then purchase extra shares of Apple separately. You are then tilted toward Apple as a company in particular and technology more generally because your S&P index fund already contains shares of Apple, giving you exposure to the company and its sector.

While there is absolutely nothing wrong with purposely tilting as a practice — it’s nobody’s business but yours — you must be wary of inadvertently doing it as you go about creating your diversified portfolio. If you never meant to tilt and your real objective was simply diversification with passive investment vehicles all along, then you’ve just shot yourself in the foot and taken on even more of what you were trying to mitigate or diversify away in the first place: risk that your actual returns will be different than expected. By paying careful attention to a fund’s holdings during fund selection, you can avoid this.

The example given above is a fairly obvious and straightforward one. Things can quickly get more opaque, though. For example, you may have heard that some professionals recommend holding real-estate-related investments as part of a well-balanced and diversified portfolio. But let’s say you already hold Vanguard’s Total Stock Market Index Fund (VTSMX), which basically encompasses all stocks traded on US exchanges. That should include some real estate investment trusts (REITs), right? Or do you now need to go out and buy shares in Vanguard’s REIT fund (VGSIX)?

The answer is both no and maybe — Vanguard’s Total Stock fund has a current weighting of around 3.75% in real estate as of the posting of this article, according to Morningstar data, and the fund is built to mimic the reality of the US markets with respect to market cap. A purely passive approach would dictate that you do not buy extra real estate shares.

However, if you want to approximate the allocation percentages recommended by some experts (10% or higher of your portfolio in real estate), you would have to buy into Vanguard’s (or some other company’s) REIT fund just enough to meet your ultimate desired allocation percentage when combined with what’s already in the Total Stock fund (6.25%+). Of course, no recommendation is being made here about whether you should or shouldn’t, I’m simply reiterating that the Total Stock fund already contains REITs and that if you purchased more shares of some real-estate-related fund, you would, by the strictest definition, be tilting away from the natural composition of the equity markets in the US as measured by market cap.

As with sector allocations in the above example, you have to be cognizant of regional allocations when it comes to diversification with international equities and the investment vehicles you have to choose from out there. Vanguard’s Total International Stock Index Fund (VGTSX) and Total World Stock Index Fund (VTWSX) allocate different amounts to emerging markets. Hence, depending upon your goals, you may be more or less weighted towards emerging market stocks than you wish to be and may have to adjust accordingly utilizing a pure long or short emerging markets investment vehicle to attain your desired allocation percentages.

Things can get yet more difficult to discern. Take the example of two funds offered by TIAA-CREF to their account holders, the TIAA-CREF Large-Cap Growth Index Fund (TILIX) and the TIAA-CREF Large-Cap Value Index Fund (TILVX). Growth and value are two different stock styles and, you would think, mutually exclusive. However, it appears that some stocks, including Johnson & Johnson and Microsoft, share spots on both lists of fund holdings. It’s true, each fund holds different amounts of each company’s stock, but suffice to say that you may be getting more of certain equities than you bargained for.

The only way to avoid accidental tilting is to do your homework — there’s just no getting around that. As always, settle upon your asset allocation percentages first (70/30 ~ stocks/bonds), then decide how those will be broken up into sub-allocations (domestic; international; growth; value).

Finally, as you select the actual investment vehicles, pay special attention to their portfolio compositions, and sector and region weightings where it comes to the broadest-based equity funds. With more narrowly-focused stock index funds such as the growth and value types, you’ll need to review the situation at the individual stock level.

As with everything else, this exercise will become easier with practice as you peel back the layers and familiarize yourself with the essence of the different funds available out there.