Why One ETF Is Not Enough

With hundreds of funds to choose from and more new ones coming out every day, it's easy to think that with ETFs, more is better. But given just how closely linked many ETFs' returns are to one particular benchmark, buying a bunch of different ETFs may not do as much good as you think -- and could in fact leave you dangerously overexposed to stock market risk.

The rise of ETFs
From their humble beginnings in the 1990s, ETFs have exploded onto the investment scene. Now, you can find investments tailored to just about any investment strategy you can think of. Want to harness the power of dividend stocks for your portfolio? You can find many ETFs that track dividend-paying stocks. Are you ready to jump into foreign stock markets for greater return potential and to protect against a downdraft in the U.S. dollar? International ETFs have made overseas investing a lot easier than it used to be.

The idea behind owning different ETFs is that you want a variety of different types of investment exposure. The hope is that when one ETF goes down, the others will go up, giving your overall portfolio a gentle but substantial rise over time.

Too much correlation
Unfortunately, many ETFs don't offer as big a difference in the way they perform as investors think. Returns of many ETFs turn out to be very highly correlated with the returns of the S&P 500. Have a look:

ETF

Correlation With S&P 500 Return

iShares S&P Global Industrials

99.1%

iShares Russell 1000 Value (NYSE: IWD  )

99.0%

WisdomTree Total Dividend (NYSE: DTD  )

98.4%

Vanguard High Dividend Yield (NYSE: VYM  )

98.2%

WisdomTree Earnings Top 100

97.7%

Vanguard FTSE All-World ex-US (NYSE: VEU  )

96.6%

Vanguard Mid-Cap (NYSE: VO  )

96.3%

Vanguard Growth (NYSE: VUG  )

96.3%

iShares MSCI EAFE Index (NYSE: EFA  )

96.0%

Source: Morningstar.

At first glance, you wouldn't expect to see this list of ETFs so closely correlated with the returns of the S&P 500. Rather, you'd probably buy these ETFs specifically so they wouldn't be correlated with the S&P's returns, expecting to see them zig when the S&P zags.

But as you can see, lots of ETFs targeting vastly different asset classes have produced similar returns lately. Here are some reasons why:

  • Not every big company pays a dividend. But when you look at the top holdings of U.S. dividend ETFs, you'll often find top S&P 500 companies near the top of the list. Similarly, ETFs based on fundamentals like earnings often gravitate toward the top stocks in the S&P 500, with the only difference being minor differences in how the stocks are weighted within the ETF portfolio.
  • Focusing on either growth or value stocks has led to much different performance over long periods of time. Recently, though, both styles have produced roughly similar results.
  • Even disparate markets like mid-cap and global stocks are starting to trade more in synch with each other. Although mid-cap U.S. stocks have outperformed their larger counterparts, they still tend to move in the same direction.

All of this suggests that you might be just as well off buying a single S&P 500 ETF than trying to build a falsely diversified ETF portfolio. But before you give up on diversification, there's still one thing left to consider.

Past performance is no guarantee of future results
The danger from any observation like this is that you apply it too broadly to your own investing strategy. Because correlation changes over time, assuming that high correlations will continue could be a big mistake.

In fact, recent correlations within the U.S. stock market have been near record levels. In other words, even inside the S&P 500, constituent stocks are moving more in lockstep than ever. Historically, though, that hasn't always been the case, and there's no reason to think that it will remain the case going forward. Different industries have different dynamics that affect them, and so their stock performance is likely to diverge over time.

The key lesson to take is that while diversification is useful, you won't always get the positive effects of diversification that you expect. In some market environments, it's very difficult to find investments that will perform differently. Over time, though, you'll find that close correlations tend to ebb and flow -- and that makes diversifying your portfolio well worth the effort.

Great companies don't always reward their shareholders. Morgan Housel recently found five companies that doubled earnings while their stocks went nowhere.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger is squarely in the more-is-better camp when it comes to diversification. He owns shares of iShares MSCI EAFE ETF. Try any of our Foolish newsletters today free for 30 days. The Fool's disclosure policy is the only disclosure policy you'll ever need.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2010, at 8:56 PM, gimponthego wrote:

    No offense, but 1 ETF is too much. I attach that feeling to handing my hard earned money over to a broker or "financial adviser." No one makes my choices for me, and hasn't for 14 years since I retired from CCU, and it all went into an IRA at my bank.

    Not one cent of new money has gone in, and I'm on the verge of tripling the orginal amount. CCU was trading at $88+ at the end of the quarter I left. Loved it when a split meant something..and luck didn't hurt!

    The foul odor wafting from Wall Street and it's attendant crooks under every rock in the country cooled this boy on allowing anyone other than myself from handling my dough. Buttermilk wasn't the only thing getting churned and what the cows left on the ground had plenty on companionship. There are many arguments no doubt..this is just my opinion. I pretty much leave the S&P in the dust.

    DD, UberFastBroadbandCable and a reliable computer of your choice is all you need. Otherwise, you're risking every cent you own.

    If you're retired, as we are (great to operate on JST...Johnny Standard Time) you can stay in front of the 'puter all day. That's paid off many a time.

    Happy Investing/Trading To All! J.

  • Report this Comment On February 04, 2011, at 5:56 PM, easyavenue wrote:

    gimponthego:

    Huh? CCU is the stock symbol for United Services Company (translated from spanish), and it has never been to $88, according to Yahoos charts. So your reference to CCU is baffling to me. What is CCU?

    Also, what exactly are you doing, besides making your own trading decisions, that allows you to "leave the S&P 500 in the dust?" Please let the rest of us know so we can do the same! Sharing is a part of what Foolishness is all about!

    Thanks.

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