Diversifying Your Portfolio: The Power Of Multiple Etfs

Exchange-traded funds (ETFs) are a great way to gain diversification and broad market exposure in a single investment. However, with the increased use of ETFs, investors can make the mistake of unknowingly overlapping companies to the point where it concentrates their portfolio more than desired. While diversification is important, it is also crucial to ensure that your holdings are not too similar, as this can lead to higher volatility and reliance on a small number of companies. When deciding whether to invest in multiple ETFs, it is essential to consider the level of overlap between the funds and choose ETFs that complement each other rather than duplicate holdings.

Pros and cons of a one-ETF portfolio vs. a four-ETF portfolio

A one-ETF portfolio offers simplicity and broad diversification, especially for those new to investing. It is a straightforward way to gain exposure to a wide range of stocks or bonds, providing a simple investment strategy with low expense ratios. For example, a single ETF like VT provides exposure to the total stock market, including international stocks, without the need for additional research or active management.

However, a potential downside of a one-ETF portfolio is the lack of flexibility in setting your asset allocation. For instance, the Vanguard Conservative ETF Portfolio (VCNS) holds 60% bonds, which may not suit every investor. Additionally, a single ETF may not provide exposure to specific sectors or strategies an investor is interested in targeting.

On the other hand, a four-ETF portfolio allows for greater flexibility and customization. For example, an investor could allocate 40% to a US total market fund, 40% to an international market fund, and 20% to a specific sector or strategy ETF. This approach provides more control over the asset allocation and the ability to target specific sectors or strategies.

However, a four-ETF portfolio also introduces more complexity and potentially higher costs due to multiple expense ratios. Additionally, it requires more research and monitoring to ensure that the ETFs complement each other and do not overlap significantly, leading to unnecessary concentration in certain holdings.

Ultimately, the decision between a one-ETF and a four-ETF portfolio depends on the investor's preferences, goals, and level of comfort with managing multiple investments. While a one-ETF portfolio offers simplicity and broad diversification, a four-ETF portfolio provides greater flexibility and customization but at the cost of increased complexity and the potential for higher fees.

How to avoid overlapping companies

Exchange-traded funds (ETFs) are a great way to gain diversification and broad market exposure in a single investment. However, with the increased use of ETFs comes the risk of unknowingly overlapping companies to the point where it concentrates your portfolio more than is desirable.

• Understand asset overlap: Asset overlap happens when you hold multiple ETFs that include the same investments, such as the same company, sector, or region. Overlapping companies can impact your ETF returns and affect how balanced your portfolio is. Understanding asset overlap helps you see where your investments might be doubling up, allowing you to maintain a well-diversified portfolio.
• Review ETF holdings: Before investing, check the top holdings of each ETF. Most ETF providers list this information on their websites. Compare the holdings of different ETFs to identify any overlaps.
• Diversify by asset class: Spread your investments across different asset classes like shares, bonds, or real estate. For example, if you already own a share-based ETF, consider adding a bond ETF. Bonds typically don't overlap with shares, helping to diversify your portfolio.
• Choose broad-market ETFs: Broad-market ETFs cover a wide range of companies across different sectors, reducing the need to hold multiple ETFs and lowering the risk of overlap. In contrast, holding a broad-market ETF and several sector-specific ETFs could lead to overlap if the broad-market ETF includes companies from the specific sectors.
• Be mindful of sector-specific ETFs: Sector-specific ETFs focus on a particular industry, such as technology or healthcare. Compare the holdings of sector-specific ETFs with any broad-market ETFs you own to avoid doubling up on the same companies.
• Invest in a diversified ETF: A diversified ETF spreads your investment across many different companies and sectors within a single fund, simplifying your portfolio and reducing the need for multiple ETFs, which can lead to overlap.
• Regularly review your portfolio: New ETFs may become available, or your investment goals may change over time. Regularly review your portfolio to ensure your ETFs continue to provide diversification and make adjustments as needed to maintain balance.
• Use online tools: Online tools, such as Sharesight's Exposure report tool and PortfolioPilot, can help you identify overlap and ensure proper diversification. These tools provide an "x-ray" view of your portfolio, allowing you to see the breakdown of top holdings and common assets across your ETFs.

By following these steps, you can help manage asset overlap and create a portfolio that aligns with your long-term investing strategy and goals.

How many ETFs are enough?

The number of ETFs you should invest in depends on your investment goals, risk tolerance, and the time you can devote to managing your portfolio. While it is generally recommended to hold between five and ten ETFs to achieve adequate diversification, there are pros and cons to consider when deciding between a one-ETF portfolio and a multiple-ETF portfolio.

One-ETF Portfolio

A one-ETF portfolio, such as the Vanguard Conservative ETF Portfolio (VCNS), can provide broad diversification and is easy to manage. It eliminates the need for rebalancing, as it is done automatically. Additionally, a one-ETF portfolio offers simplicity and low costs, making it a good option for investors seeking a straightforward, low-maintenance investment strategy.

Multiple-ETF Portfolio

On the other hand, a multiple-ETF portfolio allows for greater flexibility in setting your asset allocation. You can choose ETFs with different strategies, sectors, and geographic focuses to achieve your desired level of diversification. This approach can be beneficial for experienced DIY investors who want to build a more tax-efficient portfolio across multiple accounts. However, it requires more time and effort to select and monitor the ETFs and ensure that there is minimal overlap in holdings.

Final Thoughts

When deciding on the number of ETFs to invest in, it is essential to consider your investment goals, risk tolerance, and time commitment. While a one-ETF portfolio offers simplicity and ease of management, a multiple-ETF portfolio provides greater flexibility and the potential for more targeted diversification. Regularly reviewing and adjusting your holdings is crucial to maintain diversification and align with your investment strategy.

Active vs. passive investing

There are two main approaches to investing in Exchange-Traded Funds (ETFs): active and passive investing. Each has its own advantages and disadvantages, and investors can choose to adopt either or a combination of both strategies.

Active investing involves fund managers actively trading securities within an ETF with the aim of outperforming a specific index or benchmark, such as the S&P 500 or Russell 2000. Active funds tend to have higher fees due to the costs associated with research, trading, and the ongoing management of the portfolio by human portfolio managers and analysts. While active investing can potentially deliver better returns, there is no guarantee of outperformance, and most actively managed funds fail to beat their benchmarks or passive peers, especially over the long term.

On the other hand, passive investing involves limited transactions and aims to replicate the performance of a specific index without active decision-making. Passive ETFs tend to follow a buy-and-hold strategy, aiming to track a particular benchmark such as the S&P 500 or Nasdaq. Passive funds have lower fees since there are no human managers involved, and they generally provide greater transparency. However, passive investing does not provide any room for outperformance and may result in unnecessary transaction costs due to intraday trading.

The choice between active and passive investing depends on an investor's financial situation, risk tolerance, and level of involvement. Passive investing may be suitable for those who prefer a long-term, buy-and-hold approach and want to minimise fees. Active investing, on the other hand, may appeal to those seeking the potential for higher returns and are willing to take on more risk. Some investors choose to combine both strategies, incorporating active funds for sectors they know well and passive funds for areas they are less familiar with.

Should You Invest in Multiple ETFs?

Investing in multiple ETFs can provide diversification and potentially reduce risk. By spreading your investments across various sectors, industries, or asset classes, you decrease your exposure to any single investment or market segment. This can be especially beneficial during bear markets or economic downturns, as different sectors may be affected differently by market events. Additionally, investing in multiple ETFs can provide exposure to different investment strategies and allow you to target specific sectors or themes.

However, it is important to consider the potential drawbacks of investing in multiple ETFs. Firstly, holding multiple ETFs may result in higher costs, as each ETF typically charges management fees and expenses. Secondly, overlapping holdings between ETFs may reduce the overall diversification of your portfolio. Therefore, it is crucial to research the holdings of each ETF and ensure they provide sufficient differentiation.

When deciding whether to invest in multiple ETFs, it is generally recommended to start with a small number of broad-market ETFs, such as a total market fund or a combination of US and international market funds. As you gain more knowledge and experience, you can consider adding more specialised or sector-specific ETFs to your portfolio. Ultimately, the decision to invest in multiple ETFs depends on your investment goals, risk tolerance, and the level of diversification you aim to achieve.

How to choose ETFs for your investment portfolio

When choosing ETFs for your investment portfolio, it is important to keep in mind that the goal is to diversify your investments and reduce risk. Here are some key considerations to help you choose the right ETFs:

• Avoid overlap: While ETFs offer a simple way to diversify your investments, it is possible to have too much overlap between different ETFs, which can lead to an overly concentrated portfolio. For example, many large-cap and broad-market ETFs include companies like Apple, Microsoft, Amazon, Nvidia, and Alphabet. To avoid this, consider choosing ETFs that complement each other rather than duplicate holdings. Tools are available to help you compare ETF holdings and identify overlap.
• Diversify your portfolio: Diversification is a key advantage of ETFs, and it is important to ensure your portfolio has adequate diversification. This can be achieved by investing in a mix of asset classes, sectors, and geographies. Consider choosing ETFs that provide exposure to different sectors or markets, such as healthcare, energy, international stocks, or bonds. This can help reduce risk and improve long-term returns.
• Consider your investment strategy: Your investment strategy and goals will play a role in determining which ETFs are right for you. If you are a beginner, it is generally recommended to start with a simple, diversified approach, such as investing in a total market ETF or a balanced fund. More experienced investors may want more flexibility to choose specific sectors or adjust their asset allocation.
• Monitor and rebalance: Regularly review your portfolio to ensure it remains aligned with your investment goals and to identify any overlap or concentration. Market movements can change the weightings of holdings over time, so it is important to adjust your holdings as needed to maintain diversification.
• Keep costs in mind: ETFs are known for having low fees, but it is still important to consider the costs of each ETF, including management fees and expense ratios. Higher fees can impact your future balance, especially over the long term.
• Number of ETFs: The number of ETFs you choose will depend on your personal preferences and investment strategy. While a single well-diversified ETF may be sufficient for some investors, others may choose to hold between six and nine ETFs for adequate diversification. However, be cautious not to accumulate too many ETFs, as this can lead to over-diversification and dilute performance.

Frequently asked questions