Picking the right ETF: Diversification

PICKING THE RIGHT ETF: Diversification

First of a series of articles exploring how to sort and evaluate exchange traded funds.


The need

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

Institutions lead the use of ETFs for effective acquisition and hedging of portfolio positions. In 2008, the ability to short financial ETFs while shorting individual financial company shares was banned is only one example of the value of these instruments.

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

These articles will explore key factors for evaluating ETFs beyond simple categorization and screening. Diversification, liquidity, cost, tax efficiency and tracking error will be examined for their impact on portfolio construction.



DIVERSIFICATION


Definition

Diversification is a method to control 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)
 sector (financials, materials, technology, energy)

All of these are available via ETFs. Individual investors no longer need millions of dollars to get broad exposure.


How to measure it

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%)
 weight of maximum individual holdings (PŮR recommends 10%).


Why it is important

According to capital market theory, specific risk is not 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

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


What are you trying to do?

Are you an investor or a trader? This will impact how you choose ETFs.

Investor: Your investing horizon is 5 years plus and you’re looking to overweight areas of the economy that will outperform. You need to manage risk, so diversification is important. Selecting the more diversified ETFs from different asset classes, regions, styles, sizes and sectors is a good way to succeed.

Trader: Your investing horizon is lunchtime tomorrow (maybe up to one year). All you need to predict price movements is in price, volume and trading statistics. You gain by exploiting volatility and you trade frequently. Ironically, ETFs dampen volatility! Nevertheless, it may be easier to make a call on a sector (like financials) rather than a single security (like TD Bank ). Diversification is a two-edged sword for you, but is useful in assessing broad or specific exposure to underlying indices.

Examples

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. As we will see in a future article, cost is a very important factor.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only 5 holdings is a very concentrated ETF that would score low on diversification but may be interest traders.

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. Look before leaping.


Summary

Diversification is one 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 will discuss liquidity, important for when the $%^t hits the fan as it did in 2008.

PŮR Investing Inc. is a registered portfolio manager specializing in risk managment using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm