Are you actually diversified?

Many investment vehicles have gone in and out of fashion as technology, access and knowledge changes our investment universe. The newest craze is ETF’s. Promoting the benefit of passive investing through diversified holdings, its aimed at arming the sheepish retail players with the same returns as active finance gurus. An ETF (Exchange traded fund) is a collection of multiple individual investments, packaged into one single vehicle. It’s important to note that while ETF’s can be highly diversified, there are many types and structures that make up modern day ETF’s.

ETF’s can be weighted in three different ways. The term “weighted” refers to how much of the ETF is made up of an individual investment, and the process by which the investment team choose these weightings. Below we look at three types of weightings that could be used on a stock index ETF.

Market cap weighted ETF’s are when the size of each investment is proportionate to the market capitalisation of the company. This generally the most common type of ETF structure. While these ETF’s may claim to be diversified, the skewness of market capitalisation of the top valued firms, will mean you have more exposure to larger companies. For example, within the ASX200 index (ASX:IOZ) the top 20 companies make up almost 60% of the holdings, meaning the bottom 180 companies make up only 40% of the ETF.

Equal weighted ETF’s attempts to reverse this issue, allocating the same weighting to each investment. The investment team apply the same proportion of funds to the top companies as the bottom companies within the index. This provides more diversification across more investments. However, this may come with added risks as more of the funds are being allocated to smaller, up-and-coming companies.

The final type of ETF’s are fundamental ETF’s. While the ETF strategy does hold investments in a broad range of companies under the index, the weightings will change depending on fundamental criteria set out by the investment team. These criteria are often set rules around book-to-market ratios, cash flow, sales, or any other fundamental data. The benefit of such a strategy is the ability to capture undervalued stock while continuing to be exposed to a broad range of investments.