During times of market volatility, I always notice an influx of visitors looking for a safe harbour or the mythical holy grail to investment safety. Search terms from blog analytics are so fun sometimes!

Index investing may or may not be what you are looking for. Indeed, I have written a fair bit on index investing –

– but I have also touched on some of its potential pitfalls. Inspired by a recent comment-fest over at Singapore Man Of Leisure, I wanted to pen a quick post on some of the obvious considerations that have been pointed in the discussion. I may or may not have blogged on them before but hey? I can always repeat myself.

When we think about diversification, a really simple way to start is to think of it as being 3-dimensional as listed below –

  • Geographical / Country
  • Industry / Sector
  • Asset Classes

1. Geographical Risk

Since we’re from the sunny island of Singapore, our focus would naturally be on the little red dot we call home. As an example, we shall look at SPDR Straits Times Index ETF. Many people invest in it. I’m one of them, and I’m not saying it is a bad thing. We just need to be mindful of the implications.

Have you even thought about how much weightage does our country has when placed in a basket together with the rest of the world? One quick and easy way is to look at a world index, such as FTSE All World Index. If you were to check out the data as at 31st December 2015, Singapore has a weightage of 0.45% which is really a drop in the ocean.

One thing I would like to mention is that the 30 companies that make up the index do derive earnings that are beyond the shores of Singapore, which is a good thing, but fundamentally they are still Singapore based.

In addition, before you think that they are 30 unrelated companies, well that is not exactly the case ..

  • CapitaLand (3.66%) and Capitaland Mall Trust (2.26%)
  • SembCorp Industries (1.16%) and Sembcorp Marine (0.61%)
  • SIA Engineering (0.36) and Singapore Airlines (2.44%)

It used to be worst when the Jardine group of companies and CapitaMalls Asia were still part of the index. It pays to be mindful of these considerations.

If you are thinking of going global, a world index ETF like Vanguard’s FTSE All-World UCITS ETF or iShares Core MSCI World UCITS ETF would do a great job at extremely low cost.

2. Industry / Sector

Again, let’s look at SPDR Straits Times Index ETF. Grabbing this image off its website shows a 56% allocation to the financials sector. The three banks of Singapore – DBS, OCBC and UOB – together makes up 1/3 of the entire ETF weightage at 35%.

To put it in another way, if you are investing solely with STI ETF, you have one-third of your money on three banks in Singapore. Also, more than half of your money is invested in the financials sector. Intriguing?

sector

Looking at a world index fund like Vanguard FTSE All-World UCITS ETF, we see a more even distribution.

vwrl-sector

3. Asset Classes

I’m guessing this is pretty straight-forward.

Equities. Bonds. Gold. Property. Cash. Pick the poison of your choice? Different asset classes react differently to global conditions and a pure equities portfolio is definitely going to be a wee-bit rockier than safer asset classes. Do you have the appetite (and stomach) for it?

Building Your Own Safety Checks

Indexing investing isn’t all rosy as some people makes it out to be. Be very careful.

A basic check everyone can do is using the P/E ratio to get an idea of the expensiveness of an index. Not a perfect tool, but it gives a really good idea on whether the market is overheated. Indexing during elevated level of P/E ratios is madness.

Shenzhen Composite Index last year in 2015? P/E ratio = 50. (sorry, I cannot stop myself from mentioning this wonderfully name stock called Searainbow Holding which once had a P/E ratio of 10,000)

Dot-com Nasdaq bubble in 2000? P/E ratio = 175.

Nikkei stock bubble in 1989? P/E ratio = 70.

What if you had dollar cost average from the Nikkei peak for 25 years? You might not be as “lucky” as the chap who DCA STI ETF just before the Great Financial Crisis in 2007.

Straits Times Index ETF today in 2016? P/E ratio = 11.

Imagine a pet dog being held on a leash by its owner. It can dash ahead or lag behind, but it will always return to its rightful place. No time to do anything? Enjoy a video then – at least the first minute and fifteen seconds.

 

More Than Index Investing

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