Mind The Gaps (And Overlaps) In Your Portfolio's Core

by: Dodd Kittsley

If you ask 10 different investors what's at the "core" of their portfolio, chances are you'll get 10 different responses. But you'll probably hear some common themes, such as "long-term investments," "more stable securities," or perhaps even specific asset classes like "stocks" and "bonds."

There isn't one right answer, but the general idea is that core investments form the basic building blocks of an investment strategy - asset classes like small, mid and large cap US and international stocks, US and international bonds and perhaps even emerging market stocks. Many investors use index ETFs and mutual funds to get access to these exposures because they provide diversification and require less ongoing attention than a portfolio of individual securities. In ETFs alone, there's approximately $680 billion invested in funds that offer core exposures, which accounts for nearly 41.8% of the US ETF market. So far in 2013 we've seen $53.6 billion flow into US core ETFs (as of 10/23/13).

Despite the crucial role that core plays, many investors give it a lot less thought than they do the other parts of their portfolio. While building your core shouldn't be an arduous process (in fact, here's a tool that makes it pretty simple), you do want to make sure it's working as hard as it can for you - after all, it is the foundation of your portfolio. There are a few pitfalls that we repeatedly see issues that over time can cause your portfolio to stray from its course. Here are two common examples:

Portfolio Gaps

When you look at the index funds in your portfolio, chances are you'll see the names of a variety of different index providers, such as S&P, Russell and MSCI. What we often see is investors choosing the benchmarks they're most familiar with without thinking about how those indexes fit together.

For example, many investors will buy an S&P 500 fund and a Russell 2000 fund, thinking that the two indexes together make up the entire US market. But if you look at the illustration below, you'll see that something is missing from that combo - mid cap exposure. If you want to include US mid cap stock exposure in your core, you would need to buy a separate fund.

For illustrative purposes only - market cap spectrum not to scale.

Another common, unintentional "gap" occurs with the MSCI indexes. MSCI is one of the most well-known international index providers out there, and as such we see a lot of investors choose products benchmarked to its indexes, like MSCI EAFE and MSCI Emerging Markets (EM), in order to gain international equity exposure.

What some investors don't realize is that MSCI's standard indexes (including MSCI EAFE and MSCI EM) do not include small cap stocks. So, for example, if you own an MSCI Emerging Market fund and you also want emerging market small cap exposure, you would need to buy a separate EM small cap fund.

If you want small cap exposure and don't want to buy a separate fund, you could instead invest in a fund that's benchmarked to an MSCI Investable Market Index (NASDAQ:IMI). The IMI indexes provide comprehensive market coverage (including small cap stocks), while maintaining risk and country exposures that are extremely similar to their standard indexes (see below).

MSCI IMI vs. Standard Indexes

Portfolio Overlaps

Sometimes the problem isn't what you're missing, but what you unintentionally have too much of. Take for example the popular Russell Index series. We sometimes see investors buy a Russell 1000 fund, a Russell Mid Cap fund and a Russell 2000 fund in order to represent the total US market. But if you look at the illustration below, you can see that the Russell Mid Cap fund is actually the bottom 800 stocks of the Russell 1000 fund - so you've essentially just doubled down on mid cap exposure.

For illustrative purposes only - market cap spectrum not to scale.

When it comes to these common gaps and overlaps, the bottom line is that it's key to know what you own. There's nothing wrong with having extra mid cap stock exposure if that's what you intended to do. Building your portfolio's core is an important step in the investing process, and if you do it right, it can better help you meet your investment objectives. Because of that, it's worth taking a little extra time to make sure your core is giving you the exposure you expect.

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