ETF’s Make Great Tools for Diversification

Using index funds like ETF’s allows for a stringent design of diversification. The investment policy statement of the funds demands that all of the equities in the particular index must be held without regard to valuation or any performance prediction. Thus, the fund follows the performance and yield of the given index very carefully. When an expert designs a diversification plan, she first looks to which investments form a group in some natural way. The first major cut is to distinguish stocks from bonds. Every investor can say why those two are different; it comes down to whether or not the investor owns some of the company or lends some of his money to the company.

This difference makes the two asset classes behave differently when things change in the macro economy. As interest rates rise, some stock prices may go down as the value of bonds comparatively increases. The opposite may happen if interest rates go lower. If you own a combination of stocks and bonds, the individual components will fluctuate, but the total value of your holdings will change less. While it’s great to have a bifurcated plan of diversification, an expert can do much better than that.

Logical Groupings Help Create Sub Asset Classes

She looks for logical groupings among stocks that would make them behave in similar manners. Consider that transport, delivery and perhaps car manufacturers behave similarly, although the last may not always move in a pattern similar to the first two.

Contrast those groupings with energy stocks and consumer staples. When energy is expensive, transports and delivery services pay more for gas and report lower profits. Energy companies do well as they achieve pricing power.

Given that this type of thinking underlies good diversification, then the next step is to find out how many distinct groupings one can find that fulfill the criterion that the components move together for some logical reason and that the groups may move in directions opposite to each other given the same conditions. The companies that put together ETF’s generally take that into account in order to design and market an ETF.

Good Sub-Asset Groups Have Long Histories

The long history of a properly constructed sub-asset group makes for quite an attractive feature to our expert advisor. With years of daily data, the numbers for performance, yield and covariance in relation to other groups allow her to construct apparently stable behavior profiles. From these profiles, she can decide what percentage of your funds to allocate to each group in order to both capture equity risk premium and to increase safety through diversification.

This same quality of asset classes may also create a false sense of security among amateur purchasers of ETF’s. Normally, when a mutual fund opens its doors, it can only report its performance since inception. That should make perfect sense. An index fund, however, can report the performance of the underlying index since its composition is entirely composed of that index. The performance figures for ETF’s do not reflect the same kind of performance that a history of an active fund shows.

When a particular sector of the economy outperforms the others, the creation of an ETF around that grouping makes for easier sales to those who want to enjoy the gains without the labor of picking stocks in the outperforming area. Marketing efforts for these funds become easier as the trend continues and everyone wants to jump on board. Thus, a new index ETF may report stellar performance just as the sector or group it’s composed of heads for a fall.

Prudent Practice Avoids Trendy ETF’s

Sometimes though, the temptation to produce a product that people will buy may lead to products which don’t suit the Prudent model particularly well. A fund which holds physical silver and gold may accurately represent the precious metals as an asset class, but a fund which uses rolling futures contracts and buys or sells based on robust technical indicators doesn’t represent the type of diversifier one seeks in a prudent investing plan.

Avoid ETF Equity Overlap

Overlap represents a significant danger to a good diversification plan. Most index ETF’s hold equities on a cap-weighted basis. That means there will be more shares of expensive companies in the fund than shares of lower prices, less capitalized companies.

Consider the American behemoth General Electric (GE.) It’s one of the largest companies in the world. How would you classify it? Large cap, domestic, durable goods provider? Do you know that a large share of its business comes from its financing arm, so part of GE behaves like a bank?

GE could be a large portion of several different ETF’s. That means that a number of the parts in your portfolio you had counted on to act differently may end up acting the same way because of the elephant in the room. In order to be sure that your diversification is effective, an expert should perform a thorough drill down to check for this kind of overlap.