This Simple Change To Your Market ETF Can Give You Better Diversification

This Simple Change To Your Market ETF Can Give You Better Diversification
Theodora Lee Joseph, CFA

9 months ago1 min

Mentioned in story

It’s like that old saying about how the rich get richer: in stock markets, big companies just get bigger. And because of that, if you think that buying a market index ETF is a rock-solid diversification play, well, think again.

Just look at the UK: the main stock index, the FTSE 100, houses the country’s 100 biggest companies by market value. But its 10 burliest stocks make up more than half of the index’s market value. And, as you can see from the chart, that’s a much higher concentration than you’ll find in the US, Europe, Japan, or even in emerging markets. In other words, investing in a FTSE 100 ETF means you’re making a good-sized bet on those ten big stocks: AstraZeneca, Shell, HSBC, Unilever, BP, Diageo, Rio Tinto, British American Tobacco, GSK, and Glencore.

Those market-cap-weighted index ETFs have always seemed like a good diversification tool, but that diversification advantage has actually narrowed over time as big firms have become bigger. Before you choose a market to invest in, you’ll do well to understand the market’s concentration risk, and its breakdown, both in terms of individual stocks and sectors. If your research reveals a risk you’re not happy to take, consider investing in an equal-weighted market index ETF instead. These ETFs equally invest in each stock in an index, giving you negative exposure to the index’s overall momentum factor but positive exposure to the size and value factors. Some examples include the Xtrackers FTSE 100 Equal Weight UCITS ETF (ticker: XFEW; expense ratio: 0.25%), the iShares S&P 500 Equal Weight UCITS ETF (ISPE; 0.22%), or the VanEck Sustainable European Equal Weight UCITS ETF (TEET; 0.4%).



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