Diversification is one of the main attractions of exchange traded funds.
A single ETF can provide exposure to hundreds or even thousands of investments, allowing investors to spread risk without having to select individual securities.
However, owning several ETFs does not necessarily mean a portfolio is more diversified.
In some cases, different ETFs may hold many of the same companies, sectors or markets. This can result in greater concentration than an investor may realise.
More ETFs do not always mean more diversification
Consider an investor who owns a broad international shares ETF. That fund may already include large holdings in companies such as Nvidia, Apple, Microsoft, Amazon and Alphabet.
If the investor then adds a technology ETF, many of those companies may appear again.
A separate US shares ETF may also include the same names.
Although the portfolio contains three different ETFs, a significant proportion of the underlying investments may overlap.
This is known as portfolio overlap.
Overlap is not necessarily a problem. An investor may deliberately choose to increase exposure to a particular company, sector or market.
The key is understanding where that overlap exists and whether it is consistent with the intended investment strategy.
Look beyond the ETF name
ETF names can make funds appear more different than they actually are.
One fund may be described as a global shares ETF, another as a US growth ETF and another as a technology ETF. Despite those differences, their largest holdings may be similar.
For this reason, it is important to look at the underlying investments rather than relying on the product name alone.
Most ETF providers publish information on their largest holdings and portfolio composition.
A closer look at the underlying companies may reveal similarities that are not obvious from the ETF name alone and help identify where significant overlap exists.
Sector exposure can also overlap
Overlap does not only occur at the company level.
A broad sharemarket ETF may already provide substantial exposure to sectors such as technology, financial services, healthcare or resources.
Adding a specialist sector ETF will increase that exposure further.
Again, this may be deliberate. However, it changes the balance of the portfolio and can increase reliance on the performance of a particular sector.
Investors who hold several specialist ETFs may therefore have a more concentrated portfolio than the number of funds suggests.
Geographic diversification can be misleading
The same issue can arise with geographic exposure.
Many broad international ETFs have a significant allocation to the United States because US companies represent a large share of global equity markets.
Adding a separate US ETF may therefore increase an existing exposure rather than materially improving diversification.
This can also occur when combining global, regional and country-specific ETFs.
Before adding another fund, it is useful to consider whether it provides exposure that is genuinely different from existing investments.
Concentration can occur within a single ETF
An ETF can also hold hundreds of companies and still be relatively concentrated.
Many broad-market ETFs weight companies according to market capitalisation. As the largest companies increase in value, they can account for a greater share of the index.
As a result, a relatively small number of companies may have a significant influence on the ETF’s overall performance.
The number of holdings is therefore only one measure of diversification.
Investors comparing funds can also use resources such as InvestSMART to review how different ETFs have performed before looking more closely at their holdings, strategy and risk.
The role of each ETF matters
There is no fixed number of ETFs that constitutes a well-diversified portfolio.
A new ETF may provide valuable exposure to an asset class, market or sector that is not already represented.
However, each additional fund should have a clear purpose.
Investors may wish to consider whether an ETF:
- provides exposure that is not already present
- improves diversification
- increases concentration in existing holdings
- adds unnecessary complexity
- is consistent with the portfolio’s long-term objectives
ETFs can be an effective way to build a diversified investment portfolio.
However, diversification depends on the underlying investments, not simply the number of ETFs held.