The late, great Charlie Munger, Warren Buffett’s investing partner for more than five decades, truly saw it all. As investors get more familiar with the behind-the-scenes guy in Buffett’s Berkshire Hathaway Inc., ETF investors can take away a key lesson from how Munger approached investment research and portfolio management.
Munger’s Key: Concentrate!
This doesn’t mean concentrate on what you do, staying focused and productive. That’s a given when investing in ETFs or other securities. Rather, Munger advocated for concentrated investing: the belief that diversification is a good idea but best not taken too far.
Concentrated investing tops my own approach to ETF research and portfolio construction and tends to be a minority/contrarian view in the ETF world. But after I heard of Munger’s death at the ripe old age of 99, I thought this perspective was the best to share about this investment legend and the legacy he leaves us.
ETFs and ‘Diworsification’ According to Munger
Munger warned investors not to take the staple idea of diversifying a stock portfolio and turn it into “diworsification,” a term he used but said he did not coin. Legendary Fidelity Investments fund manager Peter Lynch used it in his book “One Up on Wall Street.” I’m happy to help carry on the concept, as I’ve written about it for decades myself. Detractors to hyper-diversification (like me) cite several studies over the years that show diversification’s benefits tend to fade sharply after 20-30 stock holdings.
For ETF investors, that might come as a shock. So many ETFs own hundreds of stocks. But there is a difference between an ETF having 200 stocks and the top 15 accounting for, say, 60% of the assets. In this latter case, those holdings drive the proverbial bus for the ETF, while the rest trail along to provide some modest benefits, a bit of a cushion.
Many ETFs are based on indexes and the index determines how many stocks the ETF owns—unless it uses an approach called “sampling.” With it, the ETF manager isn’t compelled to own all the index holdings, just enough to accurately represent the index. So, in ETFs based on indexes where many stock holdings carry very little weight, it filters out those “window dressing holdings,” a move consistent with Munger’s belief system.
Popular ETFs More Concentrated Than Many Realize
ETF investors may be surprised to learn that many very popular funds are highly concentrated. That often results from the appreciation of a relatively small number of stocks compared with the rest. In most market sectors, the big have become bigger while smaller companies lagged. In this era of historic mega caps outperforming small-cap stocks, we arrive at Munger’s concentrated approach, even if it wasn’t the original intention of those ETFs.