Diversification is widely accepted as a nearly costless way to reduce the risk of a portfolio. Diversification averages out the idiosyncratic risk that arises from unexpected events at particular companies, but it does nothing to remove market risk. When the market falls, nearly all stocks fall with it. The benefits of diversification from each new stock added to a portfolio are smaller than the diversification benefits of the prior one, but the costs of adding each new stock are nearly constant: transaction costs, and the cost of your time to do the research you need to decide this is the stock you want.
Most investors try to get the best of both worlds by buying mutual funds or exchange traded funds. I discussed the relative merits of these approaches in Part I of this series on Green Investing for Beginners. Green energy mutual funds are substantially more expensive than either green energy Exchange Traded Funds [ETFs] or stocks. The ETFs are much better than the mutual funds when it comes to costs, but brokerage commissions have fallen so low that stocks often have lower costs after just a few years.
Hence, the only good justification for buying a green energy mutual fund is because you believe the manager has superior skill, and the only good justification for buying a green energy ETF is simple diversification.
Where Mutual Fund Investors Go Wrong
If you are going to buy a mutual fund because you believe the manager possesses superior skill, you should buy just one. Countless studies have shown that the average actively managed mutual fund underperforms the similar index fund, and determining if a manager's track record is due to skill or luck is so statistically difficult that the only thing nearly everyone can agree on is that "past performance is not a reliable guide to future results." And, after they agree on that, most people go right back to studying past performance... because it's the only apparent indicator of a manager's skill that is easily quantifiable. Numbers make us feel like we know something, even if they are the result of completely random processes.
To make matters worse, most green mutual fund investors I have talked with about their holdings own small stakes in several mutual funds, so their money is being managed (very expensively) by the chronically-underperfoming "average manager." This is clearly taking diversification a couple steps too far.
Where ETF Investors go Wrong
In contrast, investors in green energy ETFs know that they cannot discern investment manager's skill, and so they opt for passively managed ETFs instead of the actively managed green energy mutual funds. (There are not yet any green energy index mutual funds I'm aware of.) Using ETFs is a much more internally consistent approach, and makes sense, especially in small portfolios where the investor does not want to take the time to research individual stocks. The problem with this approach is that the green energy sector is still very immature, and the indexes are dominated by growth companies with little or no earnings. In such an immature sector, the largest market capitalization firms (which dominate the ETFs) are not necessarily the most successful businesses. Rather, they are the companies which have caught investors' attention: the flavor of the moment. Buying and selling such companies may make sense for a speculator, but is probably not the best approach for a small investor who wants to invest money that will grow with the green economy.
When You've Eliminated Everything Else...
In short, investors in green energy mutual funds almost always underperform, and investors in green energy stocks subject themselves to excessive volatility, the very thing that diversification was meant to protect against. That makes the best strategy in my mind to build a portfolio of green energy stocks that are not the minimally profitable or unprofitable flavors-of-the-moment that dominate ETF portfolios, but are instead profitable companies doing green work that has not yet caught investors' imagination. In Part IV, I discussed the green energy sectors where profitable but untrendy companies are most likely to be found, and at the end of last year I gave you a list of ten such stocks to consider.
But is ten stocks really the right number for a green energy portfolio? There's no reason to think so, since the number owes more to David Letterman than to financial theory.
How many stocks is the right number? The answer depends on the market capitalization and liquidity of the stocks in question.
Liquidity and Return Volatility
I decided to write this article after reading Has the U.S. Stock Market Become More Vulnerable over Time?, by Avraham Kamara, Xiaoxia Lou, and Ronnie Sadka in Financial Analysts Journal. The article looks at the trends over time for systematic risk (the tendency of stocks to move in the same direction as the market) and systematic liquidity risk (the tendency for the liquidity of all stocks to dry up or increase in a correlated fashion.)
This chart shows how excess liquidity volatility, and excess return volatility of equal-weighted portfolios of small and large companies have changed over time. Here, "small companies" are those with market capitalization in the lowest 20% of the researchers' sample, and "large companies" are the 20% with the highest market capitalizations.
The clear trend over time is for portfolios of small companies to have lower excess volatility, while portfolios of large companies have mostly higher excess volatility. The authors hypothesize that this trend is the result of greater institutional dominance of the markets, especially in the form of ETFs, other index funds and basket trading. These institutions have predictable and correlated trading patterns that create greater correlation in both liquidity and return among the stocks they trade. Since most indexes are dominated by large companies, these have seen the greatest increase in correlation. Meanwhile, small companies have become less correlated with the market as a whole.
Given that the trend towards greater indexing has continued since 1985 and has not yet reversed itself, I think it is likely that the trends shown have continued. If this guess is correct, then excess volatility for portfolios of small stocks in 2010 will fall somewhere below the dotted lines, while excess liquidity for portfolios of large stocks will be mostly above the dashed lines, except for small portfolios (less than 20 stocks) of large companies.
According to these charts, portfolios of large companies rapidly reach a point of diminishing returns, at around 10 stocks for return volatility, and 25 stocks for liquidity volatility. Small companies continue or show benefits of added diversification for the largest portfolios shown, and these portfolios become less volatile than the market as a whole (i.e. achieve negative excess volatility) when they contain more than 33 companies.
An Ideal Green Portfolio
Even for a full-time market watcher like myself, I find it impossible to keep track of more than 20 to 30 companies at one time. For part-time investors, I expect the maximum is no more than 5 or 10 companies. Yet even 30 companies is too few to gain the full benefits of diversification available with portfolios of small companies.
One solution is to meld indexing with a small portfolio of actively managed small companies. The index fund (either an index mutual fund or ETF) should provide similar volatility reduction as a portfolio of about 25 stocks. If we combine the index fund with a our individual companies so that the investment in the index fund is 20-30 times the investment in each of the individual stocks, we should have a less volatile portfolio than if we had invested in the index fund alone, something which we probably would not be able to acheive without the individual small stocks.
I've shown three examples below, with five, ten, and twenty small stocks. Note that the amount invested in any one stock falls as you add more stocks, but the total proportion invested in stocks rather than the index fund increases.
This method should always be superior to using the index fund alone in order to reduce volatility because of the greater diversification benefits of small stocks compared to the ones used in index funds.
This type of portfolio also works well if you only want to devote part of your portfolio to clean energy. The index fund could be a mix of a Renewable Energy ETF and a general market index fund. The research suggests that the best choice for a general market index fund would be one that focuses on small stocks, such as IWC or FDM. You could then adjust your exposure to clean energy by changing the proportions of the index funds in the portfolio.
Earlier parts of this series, Green Energy Investing for Beginners, provide ideas about how to select the individual companies in your portfolio and and other aspects of green energy investing.
Note that this is a long-only stock portfolio. I personally combine my long positions in green energy with short positions and option hedges against broad market indexes and non-green companies. In this framework, the shorts and option hedges on index funds would slot in to the index fund portion of the portfolio, while the options in individual non-green companies would fit into the individual stock portion of the portfolio. Allocations to bond funds and other asset classes may also make sense in the "index fund" part of the portfolio if they are baskets of securities, while they should go into the individual stock part of the portfolio if they are securities of a single issuer.
DISCLOSURE: No positions.