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Dig Deeper When Measuring Diversification (Part 2)

Dig deeper

Continuing from part 1 of the article, in Exhibit 1, I have sorted the funds in ascending order by the correlation figure. Intuitively, those funds whose top 10 holdings face similar risk factors should have higher correlation figures and, thus, a lesser degree of diversification. Vanguard Telecommunications Services (VOX) had the third-fewest average number of holdings and highest percentage of its fund represented by its top 10 holdings. As sized by more rudimentary measures of diversification, this fund doesn’t stack up well. But exploring how its top 10 holdings interact with each other paints a different picture. VOX’s top 10 holdings had the lowest average pairwise correlations (28.4%) among the 20 sector funds in the sample. Conversely, Vanguard REIT ETF (VNQ) ranks well on more-basic measures, but closer analysis reveals that its top 10 holdings tend to flock together. 

170413 diversification(en)

In Exhibit 1, we see that real estate, utilities, energy, industrials, and basic materials sector funds all had correlation figures above 0.50. This makes economic sense, as firms operating in these sectors tend to share similar fundamentals. For example, fluctuating oil prices affect most energy stocks, and interest-rate changes affect nearly all real estate stocks. On the other hand, telecom, consumer discretionary, consumer staples, healthcare, and information tech­nology sector funds’ correlation figures were all below 0.50. Again, this owes to fundamentals. These sectors’ largest stocks are less correlated to the extent that they have more diverse business lines facing a more-varied set of risk factors.

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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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