The perils of naïve diversification

Many investors buy into a large number of funds to achieve diversification. The assumption is that the more stocks or funds they hold in the portfolio, the better the diversification.

This is wrong. Two funds can have huge overlaps. For example, a value weighted fund covering ASEAN and another covering Singapore will achieve minimal diversification. The top holdings in the ASEAN fund will be from Singapore anyway. In this case, it is much better to own 2 funds without overlap – a European fund and a Singapore fund, for example.

The case becomes more complex when the number of funds increases. You can own more than 10 funds, but have less diversification than another investor with 3 simple, non-overlapping funds. 
Here’s another example:

  •       Global equity fund
  •       U.S equity fund
  •       Dow Jones equity fund
  •       NYSE equity fund
  •       Global financial fund

These 5 funds will have huge overlaps. We know the biggest firms are listed in the U.S and may also be domiciled in the U.S. The largest firms may also be on the Dow Jones. Most importantly, firms in the U.S, on the Dow Jones and listed on the NYSE are likely highly correlated anyway.

We could build a simpler portfolio with much higher diversification benefits with a Japan fund, an Indonesia fund and a US fund.

Here’s a real example: CIMB FTSE Asean 40 ETF (SGX:M62) claims to invest across ASEAN. But the fund holds close to 30% of Singapore financial and telecoms stocks. Close to 70% of the fund is concentrated in financials and telecoms. This ETF is not diversified sufficiently across ASEAN.

A much better alternative to achieve ASEAN coverage is to buy ETFs covering ASEAN nations, or stocks of ASEAN nations.

Investors should read fund prospectus and avoid naïve decisions in investments.