The best argument for mutual funds is that they offer safety and diversification. But they don't necessarily offer safety and diversification.—Ron Chernow
Mutual funds—and more recently, exchange-traded funds (ETFs)—have offered safety and diversification by allowing individual investors to buy shares in many companies in order to spread risk. It is important for investors to understand what role they play and what role the fund managers’ play in ensuring proper diversification of their portfolio. Additionally, investors need to understand when fund companies fail on proper diversification, how that results in improper diversification and what impact that could have on their portfolios. We highlight what diversification is and why it is important, then discuss why an appearance of being diversified may not mean that your portfolio is truly diversified. Finally, we identify ways that fund managers and investors can damage their portfolio diversification.
The Importance of Diversification
Diversification reduces risk by allocating investments among various financial instruments, industries and other categories. The theory is that some assets will outperform in certain scenarios while underperforming in other scenarios. The benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Correlation is a statistical measure of how two securities move in relation to each other. Perfect correlation is a correlation of 1.0, which means that two securities move in lockstep with each other. Financial professionals agree that diversification is the most important component to reaching long-term financial goals.
Research supports this contention, as is illustrated by the paper by William Goetzmann and Alok Kumar, “Equity Portfolio Diversification,” from the National Bureau of Economic Research. The authors found that investors who held the least-diversified portfolios in a pool of investors earned far less than the most-diversified group of investors.
The unexpectedly high unsystematic risk (diversifiable risk) in portfolios for the study group resulted in underperformance as measured by the risk-adjusted performance of those portfolios. This evidence, in itself, is not very surprising. More surprising is the finding of significant differences between the performances of the least-diversified and the most-diversified portfolios.
The study determined that the least-diversified (lowest decile) group of investors earned 2.4% lower return annually than the most-diversified group (highest decile) of investors on a risk-adjusted basis. The economic cost of under-diversification was higher for the group of older investors, where the risk-adjusted performance differential between the least-diversified and the most-diversified investors was 3.1%
Because less-diversified investors trade more frequently, these performance estimates indicate that the net returns earned by under-diversified investors are likely to be even lower. Consequently, the net performance differential between the least-diversified and the most-diversified investor groups is likely to be higher.
What does this mean in practical terms for us? If you were among the top 10% of your demographic cohort for portfolio diversification, then you should outperform your peers in the bottom 10% of the group for portfolio diversification. By how much, you may ask? By 2.40% annually, a gap that will grow wider as you age. According to Goetzmann and Kumar, maintaining an improperly diversified portfolio is essentially just throwing money out the window.
Checking Your Diversification: An Example
While you may think you can buy a handful of ETFs and be diversified, you may not be correct. Such a portfolio of ETFs, for reasons illustrated in Table 1, can be less than optimally diversified and this will hurt returns. For example, with a four-ETF portfolio that includes iShares Russell 2000 ETF (IWM), SPDR S&P 500 ETF (SPY), Vanguard FTSE All-World ex-US ETF (VEU) and Vanguard REIT ETF (VNQ), I have assembled what, on its face, appears to be a reasonably well-diversified portfolio.
For the purposes of this illustration, the holdings are equally weighted in terms of the number of shares, but as the table shows the percentage of the entire portfolio for each ETF differs. IWM is focused on U.S. small-cap companies, SPY is focused on U.S. based large-cap companies and VEU is focused on large companies across the world. It seems reasonably well diversified among the major sectors, geographies and types. Our expectation would be that volatility (i.e., risk) would be within our acceptable parameters, and the portfolio would not have too much concentration in any one sector or type.
|ETF||Number of Shares||Price per Share||Total Investment ($)||Percentage of Portfolio||Beta|
|Strategy||Strategy Allocation (%)||Variance (Percentage Points)|
|U.S. small cap||27.9||1.7|
|U.S. large cap||57.5||12.5|
|global large cap||12.5||0.9|
The S&P 500 tracking ETF (SPY) accounts for 45% of the portfolio on a dollar basis, and with a beta (market risk) of around 1.00 has a volatility similar to the S&P 500 index (the beta for the market is 1.00). The REIT ETF (VNQ) has a beta of 0.94, which is a little less than the S&P 500’s beta. IWM and VEU have betas of 1.27 and 1.19, which is greater than that of the S&P 500. By using simple weighting by dollars and their betas, we can make a rough estimate that the beta of our portfolio is around 1.09; basically, slightly higher than the market. We should congratulate ourselves for constructing such a beautiful, well-diversified portfolio. Or should we?
Analyzing Portfolio Diversification In-Depth Online
There are a number of tools available on the Web that you can use for portfolio analysis. These tools will break down any group of stocks (or bonds) into various categories under geographic, sector and stock type categories. Sector categories would include basic materials or financial services, and geographic categories would include North America and Europe. Additional information includes the percentage of the portfolio held in each category as well as the percentage of a benchmark index held for the same category.
Such tools allow investors to analyze their portfolio’s strengths and weaknesses to better understand when the portfolio will outperform, underperform and market perform. You can use any tool that does this kind of basic portfolio analysis; however, for the purposes of this discussion I will use the X-Ray tool at Morningstar.com, part of their premium features. X-Ray graphically and numerically displays the sector, stock type and other breakdowns of the holdings of whatever ETF, mutual fund or portfolio you may select or create.
X-Ray shows us that 89% of our sample ETF portfolio is U.S. stocks (Figure 1). This may or may not be a geographic diversification issue, depending on your risk tolerance. To give perspective, the S&P 500 index by itself is nearly 98% U.S. stocks, as shown by Morningstar. By clicking Holdings Detail, and then World Regions, an investor can see that emerging markets are a very small part of our portfolio, which makes it closer to the S&P 500 index in geographic dispersion characteristics. If you simply wanted a domestic portfolio, then this could be acceptable, but if you wanted global exposure, this would be improper diversification because the portfolio is not reflecting the geographic portfolio characteristics that you are looking for. For the purposes of this article, improper diversification is defined as taking on risk in a portfolio that is unknown to (or not understood by) the creator of the portfolio. As was pointed out above, proper diversification, or identifying improper diversification, depends on setting realistic goals.
X-Ray also indicates the sector percentage for the companies held by the ETFs. For example, it indicates that 47% of the companies represented in the portfolio are in a cyclical type of sector such as basic materials or financial services (Figure 2). Again, as an individual investor it is important to understand what your risk tolerance is compared to what the tool is showing you. Cyclical sectors can perform quite well when the economy is expanding, but can perform quite badly when the economy is weak. The holdings for a benchmark, typically the S&P 500, are also provided for some perspective. Since one of the holdings in this portfolio is an ETF that tracks the S&P 500, it should be no surprise that many of the companies in the ETF are similar to those in the S&P 500. However, there can be significant variances, which can result in improper diversification depending on your goals. If, for example, the portfolio was missing a sector that you wanted to have exposure to, you could potentially just add a small investment in a sector ETF to provide you that exposure. The new portfolio will have different portfolio characteristics, but as long as you understand its risk, it is not improper diversification.
What you are likely to see is significant differences between weights by sector for the broad index compared to your holdings. It is important to understand how those differences can affect your portfolio. For example, as we mentioned above, our self-constructed portfolio has 47% of its holdings in cyclical companies. The S&P 500 index maintains only 31% in cyclicals. That is a very significant difference and will affect returns and volatility. The higher weighting and volatility of the cyclical stocks of our portfolio means that when times are good our returns are likely to beat the S&P 500, while during downturns our returns are likely to underperform the S&P 500, roughly speaking.
Investors, of course, can simply purchase an ETF or mutual fund that tracks an index such as the S&P 500, but what if you only want some of the portfolio characteristics of the index? By building a portfolio with multiple assets, you can customize the portfolio characteristics to suit your individual preferences. But it is always vital to understand how those differences could impact the portfolio under varying circumstances.
In the case of our presumed “well-diversified” portfolio from above, we can see immediately on the X-Ray report that a critical error was made during construction of the portfolio. By equal-weighting the ETF shares in our portfolio, the report shows that we have 10 times the weighting in real estate that the S&P 500 has (Figure 2). In addition, we were apparently not aware that broad ETFs like SPY and others hold real estate. While REITs have, since 1971, returned 11.9% per year on average according to Ibbotson Associates (second only to small-cap stocks) and allowed investors a liquid way to gain exposure to real estate, this is more allocation to REITs than we thought. Being heavily overweight in real estate makes the portfolio vulnerable to the vagaries of that asset class. Is that what we thought we were getting? No? Surprise!
X-Ray offers many deeper portfolio analysis tools that investors can spend hours using to gain a better understanding of their portfolio. Similar tools can be found at major brokerage websites such as TD Ameritrade, E*Trade and Scottrade. The tool you choose should, at a minimum, show you your overall holdings (all stocks held in the account) as a percent of total assets by sector as well as compared to a benchmark index.
Controlling Improper Diversification
A portfolio of ETFs, a mix of mutual funds and ETFs, or even just mutual funds that appear on the surface to be diversified can still suffer from improper diversification. This can happen after you have done all of your portfolio analysis to ensure that your portfolio has the characteristics that you desire.
One way improper diversification happens is through style drift, which is the divergence of a mutual fund from its stated investment style or objective. Style drift occurs as a result of intentional portfolio investing decisions made by management, a change in the fund’s management or, in the case of stocks, a company’s growth. Style drift can cause improper diversification when the original assumptions you have when buying a fund prove to be not entirely accurate.
You can also lose the diversification benefits of your portfolio through actions you take or don’t take, such as improper reinvestment of dividends (for example, you don’t automatically reinvest dividends or your reinvestment is substantially delayed). Such a delay can result in weighting differences between your portfolio and your goals. Over time this can result in tracking error, which in this case means deviation from the return you should have earned if you had reinvested properly. Improper diversification could also result from being unaware that two assets (that may or may not be in the same industry) are highly correlated. The problem for many investors is that they fail to understand that correlations are not stable; they actually drift over time. Investors need to be aware of these drifting correlations and adjust as necessary to maintain anticipated risk levels. For example, the correlation between Microsoft Corp. (MSFT) and Procter & Gamble Co. (PG) is 0.62. By itself, this number may not tell you much, but if you were to collect monthly correlations of these companies, for example, that would give you a good idea of the correlation coefficient drift that occurs over time. Not adjusting for drift will result in improper diversification.
Modern portfolio theory, which advocates a diversified mix of stocks and bonds, has come under attack since the financial crisis of 2008. Rising correlations within and between those asset classes have diminished the strategy’s main benefit, namely, better returns and lower risk. To remedy matters, some people believe investors need to start thinking in terms of risk diversification, or getting exposure to as many different and non-correlated types of risk as possible, including that offered by alternative investments such as arbitrage strategies, distressed debt and infrastructure investments. The correlation of returns between a 60% stocks/40% bonds portfolio and a 100% equity portfolio was 0.99 during the past 15 years. A portfolio exceptionally overweight in bonds shows a similarly high correlation.
There are tools on the Web that can help you look at the correlation of assets. Buyupside.com is one website that offers a correlation calculator. Simply enter two security symbols and the period over which you want to analyze their correlation and click submit. The website then calculates the correlation coefficient. You can also calculate each holding’s correlation coefficient in Excel using the CORREL function. Taking it a step further, in a portfolio you can multiply each holding’s correlation to a benchmark by its weight in the portfolio and sum up the numbers to determine the correlation of the portfolio to the benchmark.
Portfolios can also suffer from improper diversification when investors insist on equal weighting by shares and not dollars, as well as not adjusting for sector or geography, among other considerations. Equal weighting of your portfolio by dollars or shares may result in improper diversification by underweighting winning stocks and overweighting underperforming stocks. Investors may also suffer from a “more is better” strategy by adding more and more funds that don’t necessary add diversification and can, in fact, result in poorer diversification. Investors can also create a poorly diversified portfolio by limiting volatility. Simply avoiding volatility can cap returns while not necessarily reducing risk.
We have learned that while portfolios can be constructed that appear to be diversified, digging deeper can show that the diversification is not appropriate for the investor’s needs. It is incumbent upon the investor to educate themselves not only on how to construct a well-diversified portfolio, but also on how to keep it well-diversified over time. While a fund manager may take actions that can result in improper diversification for the fund’s investors, there are things that investors can do to minimize the chances of improper diversification. Actions such as monitoring correlations and automatically reinvesting dividends, while not huge actions, can pay off in spades by keeping the portfolio appropriately diversified. The key is to be an educated investor.