Are Your ETFs Diversified?

Not every ETF has safely diverse holdings so don’t go with your gut feeling alone

Morningstar ETF Analysts 11 October, 2010 | 1:31PM
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Along with low fees, transparency, and intraday liquidity, one of the greatest features of ETFs is instant diversification. While there are exchange-traded products which give exposure to only one specific asset (for instance, gold funds or currencies), the majority of equity and fixed-income ETFs track the performance of indices with numerous holdings, such as the EURO STOXX 50 or iBOXX Euro Liquid Corporates. Because of this diversification, investors can pick up a broad asset allocation for their portfolio with only a handful of ETFs. However, blindly picking a handful of broad indices can lead to unintended concentration, either within a particular ETF which may be surprisingly concentrated, or across your portfolio as different ETFs hold overlapping securities.

The benefits of diversification were first highlighted by Harry Markowitz in the 1950's in his paper and subsequent book, 'Portfolio Selection' (for which he was later awarded a Nobel Prize). The basic idea is that an investor can maximise a portfolio's rate of return for a given level of risk (or vice-versa, minimise its level of risk for a given rate of return) by including more securities in the portfolio. Once a portfolio cannot increase expected returns without increasing risk (or reduce risk without reducing expected returns) by adding more securities, it has reached what is known as the efficient frontier. The key is that the different securities must have less than perfect correlation, so that when one security does particularly poorly, others will be doing well simply by chance, thereby reducing overall volatility.

The same principle applies one level higher, diversifying across asset classes as well as across securities. Most portfolios should include both stocks and bond (as well as potentially other asset classes like commodities, real estate and/or hedge funds), despite the greater long-term expected returns of equities as compared to fixed income. Not only are government bonds and stocks less-than-perfectly correlated, but with a proper rebalancing process, you will be taking a little off the top of a market that's reached its peak and moved it into another asset that should perform better in the future.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.