[Editor’s Note: Do not read the following article as a recommendation to invest in ETFs. Like all investments, ETFs have risks. Some ETFs hold a relatively small number of securities. Others might duplicate investments held elsewhere in a portfolio. Diversification is no guarantee of investment success or loss avoidance. A diversified portfolio could produce negative returns if equity markets fall. Learn about the features, benefits and risks of ETFs through the ASX online ETFs course.]
A young couple wants to save for a house deposit by investing in shares for the first time. They buy an Exchange Traded Fund over the S&P/ASX 200 Index, gaining exposure to Australia’s largest 200 stocks.
They then invest in an ASX-quoted ETF over the S&P500 Index in the US, giving them exposure to international shares and over 700 companies. Later, the couple invests in an ETF over the 10 largest tech stocks in the US, and another over semi-conductor stocks.
On paper, the couple’s portfolio may appear to be off to a good start. It includes low-cost ETFs over Australian and US shares in the portfolio core aimed at achieving the market return, as well as thematic ETFs intended to act as portfolio ‘satellites’ in areas they feel they could potentially earn a higher return. Plus, the four ETFs give them exposure to hundreds of companies, seemingly making their portfolio well diversified.
But then imagine that global equity markets tumble as inflation and interest rates rise. The value of their ETFs falls, just as they were thinking of selling them to buy a house.
Diversification challenges
Welcome to the challenges of diversification, a deceptively complex topic that is central to long-term wealth creation. If the first rule of investing is capital preservation, the second must be diversification, for the two go hand in hand.
The ASX Glossary defines diversification as “spreading investments over a variety of investment categories with different performance characteristics, in order to reduce risk”.
However, in the hypothetical example above, the couple learned some painful lessons about diversification. The first was that their portfolio was not sufficiently aligned to their goals. They only wanted to invest for a few years before buying a house, meaning they could not ride out market volatility.
Second, their portfolio was 100% invested in equities rather than spread across different assets classes, such as bonds and cash. In technical terms, their investments had high “correlation”; they broadly moved in the same direction.
Third, there was significant duplication between their ETFs. The so-called “magnificent seven” tech stocks in the US (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Telsa), comprised about 31% of the S&P500 Index at end of June 2024. Yet the couple owned another ETF over the largest tech stocks in the US, and a semi-conductor ETF which also had a large weighting towards Nvidia. Not only may this kind of duplication increase concentration risk, but it could result in unnecessary fees.
Understanding diversification
It’s easy to make mistakes with diversification. They range from holding too few securities; to owning a large number of securities that are bought mostly on impulse; to having too much diversification that damages portfolios.
Peter Lynch, the famed US investor and author, coined the term ‘diworsification’ to highlight the risk of adding investments in a way that worsens a portfolio’s risk-return trade-off - like the couple did in the earlier example.
Rachel Waterhouse, CEO of the Australian Shareholders’ Association (ASA), has seen many diversification strategies and says: “I’ve met with some ASA members who only own one stock and thus have no diversification, and others who own 40-50 stocks, which is too many. I’ve heard some members say 10-20 stocks is ideal, but there’s no magic number for diversification.”
Waterhouse says high sector concentration is a risk. “Some investors have too much exposure to big-bank and large mining stocks in Australia, which hurts diversification.” The financial and materials sectors comprised 52.2% of the S&P/ASX 200 Index at end-June 2024.
Rachel Waterhouse, CEO, ASA
Another diversification risk is relying on a “cocktail portfolio”. That is, building a portfolio through a bottom-up approach based on hot tips heard at cocktail parties or from taxi drivers. The portfolio becomes a “grab-bag” of stock ideas that lack diversification.
Waterhouse suggests investors keep a spreadsheet to record why they bought securities. “It’s a good discipline to jot down why an investor bought a share or ETF, what they liked about it, and how it aligns with their financial goals. That also provides a reference point to help investors decide if it’s time to sell.”
Monitoring is another consideration, says Waterhouse. “I don’t think investors can properly monitor 40-50 stocks in their portfolio unless they are prepared to be stuck at a desk for 12 hours a day. Even then, there’s only so many stocks that one can get their head around.”
How investors approach diversification
Australian Taxation Office (ATO) data provides diversification insights based on Self-Managed Superannuation Funds (SMSF). The ATO Quarterly Statistical Report shows SMSF hold almost half of their total assets in listed Australian shares, and cash and term deposits [1]. There is comparatively little exposure to overseas assets or fixed income, which may suggest low diversification across asset classes.
Gemma Dale, Director of SMSF and Investor Behaviour, nabtrade
Data from nabtrade, a leading investment platform, provides diversification insights within asset classes. Gemma Dale, Director of SMSF and Investor Behaviour at nabtrade, says the average number of securities held by nabtrade customers is six. For SMSF funds that invest through nabtrade, it’s 12.
It’s important to consider that nabtrade’s data doesn’t include unlisted or other investments held outside of nabtrade (so it is possible that more securities are held), and that securities held can include ETFs or Listed Investment Companies that sometimes hold hundreds of stocks. So, the raw number of securities held at nabtrade might understate the true level of diversification. “Someone with six ETFs might be highly diversified if those ETFs hold lots of securities,” says Dale.
Growth in ETFs as a diversification tool is a highlight, says Dale. Remarkably, a quarter of investors who joined nabtrade during or after the 2020 COVID-19 pandemic, and who are under 40, only hold ETFs, she says.
These findings are broadly consistent with data in the 2023 Investor Study. It found a third of next-generation investors (aged 18-24) hold ETFs, which could aid portfolio diversification. However, young investors were the least diversified according to the ASX study, holding 3.1 products on average, principally because they have invested for less time.
With ETFs, Dale breaks nabtrade customers into two segments. “Older customers tend to invest in ETFs for exposure to international shares or other asset classes, having already built a portfolio of Australian shares through direct investing. For them, adding ETFs is about achieving asset allocation in portfolios.”
Dale adds: “Younger nabtrade customers are increasingly investing for the first time through ETFs. Interestingly, a great proportion of younger nabtrade customers now start with an ETF over the S&P/ASX 200 index and then build their portfolio up slowly from there.”
In Dale’s opinion ETFs are one avenue that may help to reduce an investment impediment for first-time investors: knowing which stocks to buy. Dale says: “For investors who are anxious about what to buy, or worry about making an investment mistake, an ETF over the S&P/ASX 200 Index gives them exposure to a large number of stocks and the market return.” However, before taking any investment decision, you should consult a financial advisor with an AFSL.
Portfolio construction and diversification
Shamir Popat, Senior Manager, Research Analyst at Morningstar, says diversification, in its truest sense, is potentially about “adding additional assets into a portfolio that lowers the volatility or risk profile of the overall portfolio, while keeping the returns at the same level”.
Popat breaks risk into ‘systematic’ and ‘unsystematic’. Systematic risks are market-related risks, such as macroeconomic, geopolitical and interest rates risks. In Popat’s view, “these are hard to diversify against”.
Shamir Popat, Senior Manager, Research Analyst, Morningstar
Unsystematic risks means risks that are company or sector related. “This is the component that is easier to diversify against,” says Popat. In his view, “Investors can’t control for the equity market as a whole experiencing a downturn like the [2008-09] GFC. But Popat thinks investors can control, for example, having exposure to Nvidia versus a basket of technology stocks.
Popat says investors can unwittingly overdiversify, leading to ‘diworsification’. “A person who is trying to hedge against every risk imaginable may be adding in asset classes, thinking that they are protected. But in essence they are raising the fees of the overall portfolio and increasing the amount of due diligence needed to ensure it’s all working correctly - leading to sub-par return outcomes. This is where assets added into a portfolio do not improve the risk/return trade-offs.”
Investors, says Popat, should understand ETF exposures and whether they are paying unnecessary fees. “Consider an investor who is buying an international share index ETF and also has a global share index ETF. The two index ETFs are from different index providers, but the underlying composition of the shares could be highly similar. So, an investor may believe they are diversified, but instead has just paid two different fee levels for a similar exposure.” This highlights the need to obtain advice from a licensed financial advisor before making any investment decision.
Adam DeSanctis, Head of ETF Capital Markets Asia-Pacific, Vanguard Australia
Multi-asset ETFs
Adam DeSanctis, Head of ETF Capital Markets Asia-Pacific at Vanguard Australia, says the starting point for diversification is investors understanding their financial goals, risk tolerance and time horizon. Then, developing a financial plan and constructing and maintaining a portfolio aligned to their needs.
“At Vanguard, we talk about diversification as spreading risk across different asset classes,” DeSanctis says. In his view diversification means recognising that “Investments don’t tend to move in unison each year.
"International equities might be the top-performing asset class one year, then lag the returns of other assets the following year” and “rather than trying to figure out which asset classes will perform best in a particular year, the investor holds investments across a number of asset classes, to potentially smooth returns over the long term.”
DeSanctis says Vanguard’s approach to portfolio construction seeks to apply four key principles: Goals, Balance, Cost and Discipline. He says that this means that investors have clearly stated goals; balanced asset allocation appropriate to those goals; focus on minimising portfolio costs; and have the discipline to maintain their investment approach.
For some investors, however, constructing a portfolio across and within asset classes – and maintaining it through regular portfolio rebalancing – is too complex.
DeSanctis says multi-asset ETFs, which provide exposure to different asset classes or “ready-made portfolios” as Vanguard describes it, may be an option for investors to consider, appropriately advised by a licensed financial advisor. In multi-asset ETFs, ETF issuers determine the asset allocation and rebalance it each quarter, doing the hard work on diversification, for a fee. Several multi-asset ETFs are quoted on ASX.
Multi-asset ETFs may take different forms. A balanced multi-asset ETF, for example, could have a 50/50 split between growth/defensive assets. A conservative multi-asset ETF could hold 70% of its exposure in defensive assets, and 30% in growth assets. A high-growth, multi-asset ETF could hold 90% of its investments in growth assets and 10% in defensive assets.
Like all ETFs, multi-asset ETFs, have risks. In the short term, they could underperform single-asset class ETFs if they have too much exposure to underperforming assets.
Generally higher fees with multi-asset ETFs compared to single-asset ETFs (due to ongoing asset allocation) are another risk that should be considered with appropriate advice sought.
Moreover, multi-asset ETFs could deliver a negative return in a particular year if an asset class with a high weighting in the ETF, such as equities, underperforms.
DeSanctis says multi-asset ETFs may provide benefits such as an issuer constructing and maintaining the portfolio. “Through a single investment on ASX, a retail investor can gain exposure to a diversified portfolio of equities, fixed income and other assets, in Australia and oversees, in a cost-effective way.”
However, DeSanctis adds: “Multi-asset ETFs are not for all investors” reflecting that they come with risks that need to be considered and advised upon by a licensed financial advisor. DeSanctis considers that “for those seeking diversified exposure across and within asset classes, in a manner that aligns with their financial goals, multi-asset ETFs are a consideration”. He notes that in Vanguard’s experience “interest in multi-asset ETFs continue[s] to grow each year, particularly from investors who want an ETF issuer to do the work for them on diversification.”
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[1] Based on December 2023 ATO Self-Managed Super Fund Quarterly Statistical Report.
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