Diversity Doesn't Always Equal Diversification | ETF Trends

I think it’s safe to say that the ETF marketplace has grown larger and more diverse than anyone would have imagined when the first ETF was created in 1993.  Today virtually any asset class, investment style, economic sector, industry, region, or country can be accessed via an exchange traded fund.  If you can imagine it, the odds are good that there is an ETF for it.

One might think that with the diversity of over 2,000 ETFs available, the ability to create superior portfolios is easier than ever.  The diversity of investment choices gives the investor a toolbox with almost unlimited options.  However, diversity does not necessarily mean diversification.  Just because there are more potential building blocks available, doesn’t mean that at the end of the day returns and risks of a total portfolio will wind up being much different.  From a portfolio construction standpoint, having more options from which to choose is not necessarily a cure-all.

Modern Portfolio Theory (MPT) is based first and foremost on the idea of correlations.  When Harry Markowitz introduced his seminal work, “Portfolio Selection” in 1952, the key new concept he introduced and quantified was correlations.  Markowitz was able to prove mathematically that if pairs of investments did not move in lock-step with one another, if the correlations between assets were low, then the overall volatility of a portfolio would be reduced.  This is MPT in a nutshell.

And therein lies the rub.  While it is true that uncorrelated investments will reduce risk, the flipside of that proposition is that highly correlated assets won’t do much of anything to reduce risk.  Portfolios comprised of small positions in many highly correlated ETFs won’t have risk-return characteristics all too different than that of a single broad-based ETF.

This was illustrated when the idea of “style boxes” dominated the thinking on portfolio construction 10-15 years ago.  Back then divvying up the U.S. market into styles was all in vogue.  It started simply enough, with a distinction being made between large cap and small cap companies.  Next people started thinking of growth stocks and value stocks as different animals.  When Morningstar introduced its trademarked 3×3 style box, the ideas of midcap and blend/core was added to the equation.  At that point, people started to go a bit overboard- megacaps, microcaps, and “SMID-caps” were added to the mix.  Even existing styles were further subdivided… deep value vs. relative value, momentum growth vs. growth-at-a-reasonable price.

The pie charts below illustrate how equity markets were divided into smaller and smaller slices in the pursuit of diversification.  But there’s one glaring flaw with this approach….the equity market hasn’t gotten any bigger as a results of these gymnastics.  There are no new assets being created by this process.  The same market is just being divided and subdivided into ever smaller pieces.