Is Your Goal to Mimic a Benchmark?

Many investors create portfolios that aim to mimic some benchmark of the market, which is a standard against which the performance of a security, mutual fund, or investment manager can be measured. Generally, these portfolios are highly diversified, often comprising hundreds of stocks of varying sizes, values, industries, and histories. The strategy of benchmark investing as described above generally is derived from two primary goals: avoiding significant underperformance and mitigating risk.

Creating a portfolio with hundreds of stocks that aim to mimic a market benchmark allows advisors, and their clients, to compare their performance to that of the overall market that the benchmark is measured against. The goal here is to not underperform the market by too much. When Warren Buffett stated that the first goal of an investor should be to not lose money, one could argue that he meant an investor should not go into an investment prepared to lose money. Aiming merely not to underperform the market by too much is antithetical to Buffett’s theory, which could also conclude that underperforming the market implies an anticipated loss compared to the alternative of simply investing directly in the market. Most importantly, attempting to avoid underperformance by aiming to mimic a benchmark may severely limits a portfolio’s ability to perform well against the market.

In terms of mimicking a benchmark to pursue the goal of risk mitigation, one cogent challenge to the argument that more stocks in a portfolio will lead to less volatility is the Law of Diminishing Returns. This well-founded economic theory argues that once a certain threshold has been achieved, each additional unit (or stock) produces less benefit than the previous stock. Prevailing research (1) has put numbers to this theory in finding that a concentrated portfolio comprising 20-25 stocks is exposed to the same level of volatility as a portfolio comprising 100 or more stocks.

We believe that a concentrated portfolio with a high active share can offer an alternative to benchmark investing. Active share (2) means as long as the 20 or so companies in a concentrated portfolio are well-diversified (3), the portfolio is more likely to provide the same level of risk as a benchmark mimicking portfolio, but with a greater chance of outperforming the market.

In aiming to mimic a benchmark with portfolios of 100 or more stocks, investors generally cannot conduct thorough research in all 100 companies to anticipate how they might fare compared to the market and therefore cannot intentionally craft a portfolio to outperform what it is aiming to copy. In our opinion, being able to conduct in-depth fundamental research into each company that makes up a concentrated portfolio is an optimal way to optimize diversification as the key to mitigating risk and pursuing capital appreciation.

The TrueShares Low Volatility Equity Income ETF (DIVZ) seeks to provide capital appreciation through an actively managed, concentrated portfolio comprising 25 to 35 favorably valued companies with attractive dividends that the portfolio managers expect to grow over time. This dividend portfolio with high active share seeks to deliver lower volatility than the overall market, which we’ve established can be possible with as few as 20-25 stocks. DIVZ focuses on companies with market capitalizations of $8 billion or greater while also focusing on diversification across industries, including healthcare, telecom, retail, defense, finance, energy, biotech, service, and security.

If an investor’s goal is to match the market without underperforming too much, then large portfolios with excessive diversification may suit that goal just fine. An investor seeking to outperform the market and with an appetite for lower volatility, could consider diversification in a concentrated portfolio.

Learn more about TrueShares Low Volatility Equity Income ETF (DIVZ) at