Is Your ETF Diversified Enough?
Diversification is the only free lunch in the stock market. Successful investors know this and diversify their portfolios as best they can.
But diversification also matters for exchange traded funds. ETFs have diversification built in, as they hold multiple stocks. However, there is more to ETF diversification than meets the eye.
Below we give a guide to what investors should look for and explain our approach to building ETFs.
Step #1. How many stocks does an ETF own?
The first thing investors should do is the simple thing: look at how many stocks an ETF owns.
ETFs always hold a range of stocks. They do this because diversification ensures investors suffer less from sharp fluctuations in individual stocks.
The number of stocks required for diversification differs between ETFs. While holding too few stocks risks undermining diversification, owning too many risks diluting an investment strategy.
At Global X, our ETFs hold between 10 and 500 stocks. With the number of stocks tailored to fit the relevant investment strategy.
At the low end, our Global X FANG+ ETF (ASX Code: FANG) holds just 10 stocks: the global “FANG” technology titans like Facebook, Amazon, Apple, Netflix and Google. While this fund only holds 10 stocks, we believe it is appropriately diversified. This is because the selected stocks are diversified in their operations and products.
At the higher end, our Global X Biotech ETF (ASX Code: CURE) holds We believe the larger number of holdings is more appropriate for diversification in biotech. This is due to sometimes extreme volatility of small biotech companies.
Step #2. How is the ETF weighted?
Second, investors should look at how an ETF weights the stocks that it holds. Does an ETF use market weighting? Or does it use an alternative weighting like equal weighting, modified market weighting, or tiering?
Market weighting is the most common. This means an ETF buys companies based on how big or small they are. Big companies get more weight, small companies get less. Market weighting often works well. For example, the S&P 500 and ASX 200 use it to great effect.
However, market weighting is weaker in other areas. Especially in markets where one company is very dominant or influential. Taiwan’s national stock market is one example. In October 2021, Taiwan semiconductor giant TSMC, took 23% of Taiwan’s national stock market gauge.. Meaning that market weighting left investors heavily exposed to a single company.
Alternative approaches to market weighting include equal weighting, tiering and modified market weighting. Equal weighting gives every company an equal slice of the pie. It thereby prevents one single stock becoming too influential—like TSMC in Taiwan. Tiering, by contrast, divides companies up like layers on a wedding cake. What tier a company falls into will determine how much or how little weight it gets. While modified market weighting puts a cap on how big or how small the biggest or smallest companies can be.
Global X uses a variety of weighting schemes across our ETFs. Global X FANG+ ETF, discussed above, uses equal weighting, while Global X Global Robotics and Automation ETF (ASX Code: ROBO) uses tiering. For all our ETFs, we consider what type of weighting will give investors the best diversification for any given strategy.
Step #3. Does the ETF cause overlap?
Lastly, investors should check if an ETF holds shares that they already own. If they do, investors should ask themselves if they are comfortable with doubling up on a specific stock. This is especially true for investors that use more than one ETF in their portfolio.
For example, in our own line of ETFs there is a small degree of overlap. Much of the overlap between our ETFs owes to one company: Nvidia – the Californian semiconductor designer.
Nvidia designs the sophisticated microchips that are used in robotics and artificial intelligence. This earns it a place in our Global X Global Robotics and Automation ETF (ASX Code: ROBO). Nvidia is also in the Global X Semiconductor ETF (ASX Code: SEMI), as it is one of the largest semiconductor companies in the world. Finally, Nvidia is one of the world’s technology titans, earning it a spot in the Global X FANG+ ETF (ASX Code: FANG).
In the instance of Nvidia, we are aware of the overlap and having assessed potential risks, are comfortable with it, given Nvidia’s unique technology. However, investors who own multiple ETFs should conduct their own research to identify overlaps. Where overlap exists, they should check that they are comfortable with it.
What does diversification mean for you?
Diversification means different things to different people. One of the great advantages of ETFs is that they provide diversification instantly. As ETFs are fully transparent, investors can determine whether an ETF provides the right type of diversification for them.