Diversification is a crucial aspect to consider when constructing a portfolio. At its core, diversification is the mitigation of risk by holding investments with different characteristics such as different regions, asset classes, industries and maturities – ultimately, it’s about spreading risk and reward out.
The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, generate higher long-term returns with lower levels of risk than any individual holding or security.
With ETFs often being composed of hundreds and sometimes thousands of underlying securities, investing in an ETF already offers more diversification than buying one individual security. However, investors need to consider how two ETFs behave in relation to one another; if two ETFs are strongly correlated with each other they may not be very good diversifiers (for example, a BlackRock S&P 500 ETF and a Vanguard S&P 500 ETF). For diversification to be best utilised, the portfolio should be made up of ETFs which are not strongly correlated with one another. We touched on diversification at an ETF level here.
By using ETFs to construct a portfolio, investors are already gaining some level of diversification, as each ETF will be composed of many underlying holdings. Combining several more ETFs will further enhance this. It is, however, possible to have too much diversification.
Over-diversification occurs when an investor holds so many securities that their portfolio suffers as a result. This is sometimes known as “diworsification”.
Over-diversification causes a portfolio to suffer in two ways:
- It increases transaction costs. Every time a security is bought or sold, there will be a cost to the investor. Some platforms will charge an explicit trading fee (although InvestEngine does not), but all investors will pay what’s known as “bid-ask spread” on their trade. This is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. The spread is a transaction cost. By holding too many ETFs in a single portfolio, the number of transactions required to establish and maintain the portfolio will result in high transaction costs.
- It increases complexity. Managing an over-diversified portfolio can become complex and time-consuming. It may require extensive research and analysis to stay updated on each investment’s performance, while monitoring and rebalancing multiple investments can be overwhelming.
- It is less tailored. Owning many hundreds of securities results in a less manageable portfolio, and reduces the chance of the overall portfolio aligning with the investor’s individual risk profile. A portfolio formed by buying many assets across many asset classes will result in an unwieldy portfolio, and will be less likely to match the investor’s investment objectives, time horizon, or attitude to risk.
Things to consider to when diversifying
While there is no magic number for a perfectly diversified portfolio, investors need to consider their investment objective and time horizon.
Asset class and sector correlation are crucial when efficiently diversifying a portfolio. Adding two ETFs which are almost perfectly correlated (for example, two global equity trackers) adds very little value. Instead, to boost diversification, investors should seek investments which do not have similar holdings or performance.
Focusing on over-diversification without having the full knowledge of the correlation between each ETF can also easily lead to a distortion in the portfolio’s overall risk level.
As mentioned above, over-diversification may move the portfolio away from the original mandate. As more ETFs are added to a portfolio, an investor may lose track of the target asset class split, foreign currency exposure and or regional allocation. This problem can be mitigated by using InvestEngine’s portfolio view, which consolidates all the exposures within the platform, as well as the One-click Rebalance feature, which allows investors to quickly and easily bring portfolio allocations back in line.
How to avoid diworsification
Diversification is best achieved by selecting several low-correlated funds, with a high number of underlying securities, whilst adhering to the investor’s investment objectives, risk tolerance, and investment horizon. ETFs have enabled investors to gain access to immediate diversification. However, buying a single ETF does not guarantee sufficient diversification (for example, a single cryptocurrency ETF does not make for a strong portfolio), and buying many dozens of ETFs results in an over-diversified portfolio.
Avoiding over-diversification requires the investor to decide on an optimal number of ETFs to hold, which maximises the level of diversification without increasing the number of holdings by so much that the portfolio begins to suffer from diworsification.