Exchange-traded funds (ETFs) have had the most profound impact on personal investing since the introduction of the modern mutual fund in 1924. To the myriad strengths that drove mutual funds to growth – diversification, professional management and shared expenses – ETFs have added low costs, transparency, market access throughout the trading day, and tax efficiency.

Institutions have traditionally led the use of ETFs for effective acquisition and hedging of portfolio positions. The ability to short financial ETFs while shorting individual financial company shares was banned in 2008, and is just one example of the value of these instruments.

With more than 100 ETFs trading in Canada, over 800 in the U.S. and somewhere in excess of 500 in registration, this rapidly expanding universe demands better selection tools.

What is diversification?

Diversification is a method of controlling risk by limiting exposure to any one holding. Institutions typically diversify by:

  • asset class (stocks, bonds, cash, real estate, commodities, currency);
  • region (domestic, foreign, emerging markets);
  • style (value, growth, core);
  • size (large cap, mid-cap, small cap); and
  • sector (financials, materials, technology, energy).

Individual investors no longer need millions of dollars to get broad exposure. All of these diversification tools are available through ETFs.How is it measured?

The quantitative way to measure diversification is by measuring the specific (idiosyncratic) risk in a portfolio. The less specific risk there is, the better the diversification. Specific risk is the risk “specific” to a security, not explained by systematic market factors (such as energy prices, interest rates, etc).

Specific risk is a metric routinely calculated by risk models. Investors without access to risk models can use PŮR’s “rule of thumb” approach:

  • total number of securities (PŮR recommends at least 50);
  • weight represented by the top 10 holdings (PŮR recommends under 30%); and
  • weight of maximum individual holdings (PŮR recommends 10%).

According to capital market theory, specific risk isn’t rewarded. That’s why minimizing exposure to this risk by increasing diversification makes sense. Better diversification can mean less variability in a portfolio’s value. Professionals call this risk management; investors call it sleeping at night.

How it works

Diversification is based on the idea that prices of assets can move independently of one another (uncorrelated). Good diversification means lots of different risks, not lots of different assets, as many investors often tend to think. An ETF’s risk is more reliable than individual securities because it is dampened by the variety and number of its holdings. The result offers a more effective approach to portfolio construction.

Single commodity-based ETFs represent pure systematic risk. They are asset classes by themselves. Some U.S. ETFs track commodity indices that have different sector concentrations. So, look before you leap.

An ETF’s diversification is a function of the number, concentration and nature of its holdings.

iShares CDN Large Cap 60 Index Fund (Symbol: XIU) with 60 holdings vs. iShares CDN Composite Index Fund (Symbol: XIC), with 220 holdings, illustrates similar ETFs with different diversification. While similar, the XIC is somewhat better. This doesn’t necessarily mean that XIC is the better choice, however. Cost is a very important factor as well.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only five holdings is a very concentrated ETF that would score low on diversification but may interest traders.

Without doubt, diversification is one of the most important factors in ETF evaluation. It is central to portfolio construction and an important reason for ETF popularity today. In the next issue, we’ll discuss liquidity, which can be important when the economy hits the fan as it did in 2008.

PŮR’s free ETF screener is available here .