BP Share News (BP.)

By Michael Casey A DOW JONES COLUMN Diversify. Diversify. Diversify. For years it was a trusted mantra: the simple idea that to mitigate the impact of nasty surprises from one company or sector, investors should hold a diversified portfolio of stocks from a cross-section of industries. The best way, it was thought, was to buy a broad market index, either via an index fund or an index-based exchange-traded fund. Yet the sad tale of BP PLC and London's FTSE 100 exposes a key flaw in contemporary diversification strategy. A bias toward market capitalization in many indexes means investors end up with excessive holdings in the biggest stocks. With that comes greater exposure to company-specific risks, diminishing the portfolio's diversification benefits. Take BP. The day before the Deepwater Horizon rig exploded April 20, the oil giant had a market capitalization of GBP121 billion ($178 billion), giving it a weighting of 8.22% in the FTSE 100. That ranked it alongside Royal Dutch Shell and HSBC as the index's biggest components. BP then represented 6.7% of the London Stock Exchange's total market capitalization. Not surprisingly, the subsequent 45% plunge in BP's share price until Monday hit the FTSE hard. BP accounted for more than a third of the index's 10% loss since April 20, FTSE's press office calculates. If not for BP, the FTSE 100 would have outperformed the S&P 500, which is down 9% over the same period. BP's market cap has since shrunk to GBP64.4 billion, reducing its weighting to 4.8%. But the damage has been done. It's a similar story elsewhere. Looking to invest in Argentina? You may not want to buy its main index, the Merval. Not only does the country's relatively small energy sector account for almost half the index, but its biggest component, with a whopping 26% weighting, is Tenaris SA. It is a Luxembourg-incorporated steel tube maker with entirely overseas operations servicing non-Argentine oil drillers. At issue isn't diversification, which remains a sound idea. It's that market cap-based indexes have the perverse effect of diminishing diversification. This problem, thrust into prominence by the bursting of the tech-heavy Nasdaq bubble in 2001 and then emphasized by the 2008 crisis, has spawned a cottage industry. Technicians are now trying to better approximate a risk-neutral benchmark. One solution lies in equal-weight ETFs, funds which assign each component in an index the same weighting. Yet these suffer from the other extreme, giving too much weight to volatile small companies. Paris-based asset manager Tobam offers an alternative: "anti-benchmark" indexes. Instead of market capitalization, these assign weightings that favor a combination of low historical volatility and low mutual correlations. But the firm doesn't have yet ETFs available. Until more sophisticated products are developed, investors need to realize that diversity in investing isn't necessarily synonymous with an index fund. -Write to Michael Casey at michael.j.casey@dowjones.com (TALK BACK: We invite readers to send us comments on this or other financial news topics. Please email us at TalkbackAmericas@dowjones.com. Readers should include their full names, work or home addresses and telephone numbers for verification purposes. We reserve the right to edit and publish your comments along with your name; we reserve the right not to publish reader comments.) (END) Dow Jones Newswires June 15, 2010 14:24 ET (18:24 GMT)