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Dig Deeper When Measuring Diversification (Part 1)

The more the merrier?

An index fund that follows a well-constructed bench­mark and levies a low fee is usually a winning proposition. Market-cap-weighted indexes are particu­larly attractive, given that they outsource the work of price discovery to active market participants and tend to have low turnover. Market-cap weighting typically works best in those instances where an index is broadly diversified—as in the case of a total U.S. stock market index, for example. But market-cap weighting stocks within a smaller investment opportunity set, such as a sector, can create a concentrated port­folio and may introduce a greater level of stock-specific risk. How should investors evaluate a concen­trated fund’s level of diversification or lack thereof?

Here I take a look at a variety of metrics one might use to size up a fund’s level of diversification. I apply them to a sample of equity sector ETFs listed in the U.S. These funds’ underlying indexes market-cap weight stocks from narrow investment opportunity sets (U.S. equity sectors). State Street Global Advisors and Vanguard offer sector ETFs with track records spanning at least 10 years. Vanguard offers an ETF covering each of the 11 Global Industry Classification Standards sectors. State Street offers just 10 sector ETFs, as it combines the information technology and telecom sectors into one fund: Technology Select Sector SPDR ETF (XLK). Also, given its brief track record, I exclude Real Estate Select Sector SPDR (XLRE) from this analysis.

Common metrics investors might use as a proxy for a fund’s degree of diversification include (1) its average number of holdings and (2) the percentage of the fund’s assets invested in its top 10 holdings. But these are blunt instruments. To address their shortcomings, I also assess these funds’ level of diversification by looking at the average pairwise correlations of their top 10 holdings. All of the data I used was sourced from Morningstar Direct and spans the 10-year period ended December 2016.

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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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