A key selling point of broad market index funds and exchange traded funds is diversity, but upon closer examination, some funds may lack the diversity investors were expecting. The Nationwide Maximum Diversification U.S. Core Equity ETF (NYSEArca: MXDU) uses a unique methodology to help investors enhance equity market diversification.
MXDU tries to reflect the performance of the TOBAM Maximum Diversification® USA Index, a diversified rules-based index of large- and mid-sized U.S. companies that uses a quantitative model to weight companies to maximize the TOBAM Diversification Ratio® of the index. The TOBAM Diversification Ratio® is a patented, proprietary metric based on the volatility of each index constituent and its correlation to other constituents.
TOBAM, the index creator for MXDU, “uses the ratio of the weighted average volatility of a portfolio’s holdings to the portfolio’s volatility, which it calls the Diversification Ratio,” said Morningstar in a recent note. “This is based on the idea that diversification should reduce the portfolio’s risk relative to the risk of its holdings. The diversification ratio is larger for portfolios that hold assets with lower correlations to each other because uncorrelated risk largely offsets at the portfolio level.”
The top 500 equity securities by market-cap are taken and are then subjected to a marginal risk contribution calculation based on the security’s volatility and correlation to other securities for the past year. Securities are then ranked by marginal risk contribution, and 50% of those with he lowest marginal risk contribution are selected.
MXDU, which debuted in September 2017, holds nearly 500 stocks and has a defensive tilt. Healthcare and consumer staples names combine for nearly a third of the fund’s weight.
“The fund tends to tilt toward stocks with a high ratio of firm-specific (idiosyncratic) to nondiversifiable (systemic) risk because they typically have low correlations with one another,” said Morningstar. “These stocks tend to have lower-than-average sensitivity to market risk (market betas of less than 1.0), though the fund still includes some names with high market risk.”