by Hareesh N Jayanthi

The best argument for mutual funds is that they offer safety and diversification. But they dont necessarily offer safety and diversification. Ron Chernow

Mutual fundsand more recently, exchange-traded funds (ETFs)have offered safety and diversification by allowing individual investors to buy shares in many companies in order to spread risk. It is important for investors to understand what role they play and what role the fund managers play in ensuring proper diversification of their portfolio. Additionally, investors need to understand when fund companies fail on proper diversification, how that results in improper diversification and what impact that could have on their portfolios. We highlight what diversification is and why it is important, then discuss why an appearance of being diversified may not mean that your portfolio is truly diversified. Finally, we identify ways that fund managers and investors can damage their portfolio diversification.

The Importance of Diversification

Diversification reduces risk by allocating investments among various financial instruments, industries and other categories. The theory is that some assets will outperform in certain scenarios while underperforming in other scenarios. The benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Correlation is a statistical measure of how two securities move in relation to each other. Perfect correlation is a correlation of 1.0, which means that two securities move in lockstep with each other. Financial professionals agree that diversification is the most important component to reaching long-term financial goals.

Research supports this contention, as is illustrated by the paper by William Goetzmann and Alok Kumar, Equity Portfolio Diversification , from the National Bureau of Economic Research. The authors found that investors who held the least-diversified portfolios in a pool of investors earned far less than the most-diversified group of investors.

The unexpectedly high unsystematic risk (diversifiable risk) in portfolios for the study group resulted in underperformance as measured by the risk-adjusted performance of those portfolios. This evidence, in itself, is not very surprising. More surprising is the finding of significant differences between the performances of the least-diversified and the most-diversified portfolios.

The study determined that the least-diversified (lowest decile) group of investors earned 2.4% lower return annually than the most-diversified group (highest decile) of investors on a risk-adjusted basis. The economic cost of under-diversification was higher for the group of older investors, where the risk-adjusted performance differential between the least-diversified and the most-diversified investors was 3.1%

Because less-diversified investors trade more frequently, these performance estimates indicate that the net returns earned by under-diversified investors are likely to be even lower. Consequently, the net performance differential between the least-diversified and the most-diversified investor groups is likely to be higher.

What does this mean in practical terms for us? If you were among the top 10% of your demographic cohort for portfolio diversification, then you should outperform your peers in the bottom 10% of the group for portfolio diversification. By how much, you may ask? By 2.40% annually, a gap that will grow wider as you age. According to Goetzmann and Kumar, maintaining an improperly diversified portfolio is essentially just throwing money out the window.

Checking Your Diversification: An Example

While you may think you can buy a handful of ETFs and be diversified, you may not be correct. Such a portfolio of ETFs, for reasons illustrated in Table 1. can be less than optimally diversified and this will hurt returns. For example, with a four-ETF portfolio that includes iShares Russell 2000 ETF (IWM ), SPDR S&P 500 ETF (SPY ), Vanguard FTSE All-World ex-US ETF (VEU ) and Vanguard REIT ETF (VNQ ), I have assembled what, on its face, appears to be a reasonably well-diversified portfolio.

For the purposes of this illustration, the holdings are equally weighted in terms of the number of shares, but as the table shows the percentage of the entire portfolio for each ETF differs. IWM is focused on U.S. small-cap companies, SPY is focused on U.S. based large-cap companies and VEU is focused on large companies across the world. It seems reasonably well diversified among the major sectors, geographies and types. Our expectation would be that volatility (i.e. risk) would be within our acceptable parameters, and the portfolio would not have too much concentration in any one sector or type.