How To Diversify Your ETFs

How To Diversify Your ETFs
Theodora Lee Joseph, CFA

over 1 year ago1 min

Mentioned in story

Markets may be in the red, sure, but you can’t tar all companies, sectors, and regions with the same brush. Case in point: higher rates, rampant inflation, and fears of a recession have given tech stocks and Chinese companies an especially brutal hammering. So because diversification can help you protect your portfolio from such massive swings, let’s check out how that applies to exchange traded funds (ETFs).

Diversification isn’t just about how many stocks you have in your portfolio, it's also about which types of stocks you buy. You can see how that rule’s played out in ETFs this year: the truly diversified equal-weighted S&P 500 index has performed at least 200 basis points better than the market capitalization-weighted one. Let me explain: market capitalization-weighted ETFs weigh each stock based on how much the individual company is worth, so the overall bundle tends to reflect market bubbles – or stocks that have done very well over a period of time. On the other hand, equal-weighted ETFs won’t go overly heavy on popular stocks or regions. That matters: when the recent selloff wreaked havoc on tech stocks, equal-weighted ETFs saw a much smaller dent than ones with a heavier tech presence.

With stock returns getting more dispersed and big market crashes more common, you’ll want to make sure you choose your ETFs wisely. After all, the same ETFs that worked when the markets were up might not be the ones that’ll help on the way down. But you can easily assess how diversified an ETF is: simply check that its holdings are split roughly equally across sectors and regions.

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