Building an ETF portfolio: Is it even possible to diversify?
I want to start investing my money. I've decided to invest a monthly fixed amount by buying ETFs. I am currently investigating different ETFs to decide on what my portfolio allocation will look like.
After a bit of research, I found out that a good place to start is to look at what Vanguard offers. So I did just that.
I noticed that Vanguard offers ETF that don't seem that differ much. For instance, how different can the 1) Vanguard Mega Cap (MGC), 2) Vanguard Mega Cap value (MGK) and 3) Vanguard Mega Cap Growth (MGV) really be?
To answer that questions, I ran the correlations on some of Vanguard's funds
Correlation Matrix on Vanguard ETF's
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So this seems to answer my question. The funds mentioned above have a correlation > 99.7%.
We also see that the correlations is extremely high on a number of these funds. For instance between the Vanguard S&P 500 (VOO) and the Vanguard Total Stock Market (VTI) we have 99.97% and between the Vanguard S&P 500 (VOO) and the Vanguard Extended Market (VXF) we have 99.2%.
With numbers like these, combining these ETF's in a portfolio makes no sense since they all move exactly the same way. I should therefore just pick one by looking at the traded volume and the management fees.
For the sake of the ETF, let's pick the Vanguard Total Stock Market (VTI).
In the correlation matrix, I see that 2 funds stand out by having a lower correlation with the VTI. These are the Vanguard FTSE Emerging Markets (VWO) and Vanguard FTSE Europe ETF (VGK). There have - respectively - a correlation - compared to VTI - of 69% and 85%. Also, their own correlation is of 79%.
So here we have it. On one hand a non-diversified portfolio composed only of 1 ETF, the VTI. And on the other a diversified portfolio composed of 3 ETF's: the VTI, the VWO and the VGK. Let's assume an allocation of 50%, 25% and 25%. In the following example, I will also assume perfect monthly re-balancing.
Let's have a look at the results.
VTI ETF versus Diversified Portfolio
We can see that both portfolios show pretty much the same story.
Naturally, I've also computed the correlation between both portfolios. The result is 98%.
With such a high correlation, it's no surprise that the diversified portfolio slightly under-performs: the management fees twice as high!
Portfolio VTI: 100% * 0.04% = 0.04%
Portfolio "Diversified": 50% * 0.04% + 25% * 0.14% + 25% *0.10% = 0.08%
From this little experiment it seems like the only sensible move is to put all my money on the cheapest Total Stock ETF I can find (basically any of the "S&P 500", "Extended Market", "Total Stock", "Mega Cap", etc. funds).
What do you think on this? Am I missing part of the picture? Does diversification hold benefits I haven't considered? Am I looking at diversification in the wrong places (maybe I should consider industry rather than geography)?
Any insights on this is more than welcome! :-)
Update: I have added 2 more funds to the correlation matrix: a small-cap ETF (VB) and a mid-cap ETF (VO).
Updated Correlation Matrix
(1)1 Comments
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As these Vanguard index ETF hold many stocks, this might be clearer if you consider the underlying portfolio of stocks that you end up with when buying these funds. For instance, in your first example Vanguard Mega Cap is an ETF of all mega cap stocks including almost all of the stocks in Vanguard Mega Cap Value and Vanguard Mega Cap Growth (check the holdings for each). You can (essentially) make MGC by combining MGK and MGV. So, adding these two funds does not diversify a portfolio with just MGC.
However, VTI (US stocks) holds an entirely different set of stocks than VGK (Europe) and VWO (Emerging). So holding all three is diversifying in this case. To understand diversification, it's better to check correlation amongst the funds as you are interested in to see how they relate to each other. Now, the correlations amongst these three funds may be rather high all around ~0.75 (daily, 5/3/2018, last two years, Bloomberg), but that is still a good amount of diversification. I think it is great you are checking fees closely not enough people do that, but a tiny extra fee of 0.04% is likely worth that extra diversification.
If you look at the holdings some more you will notice that funds like VTI are already broadly diversified across industries (see the "Equity sector diversification" section. It is also diversified across company size. You can check and see that the stocks in MGC are in VTI but VTI holds smaller stocks as well. Besides geography and size, other common diversification directions (with even lower correlations to equity) are bonds (BND), real estate (VNQ) and commodities (though I find commodities tough to recommend).
Addition to clarify:
We can see that both portfolios show pretty much the same story
Actually those two portfolios (100% VTI and Diversified) are very different over the time period you explore. The correlation being high only means they tend to change in the same "direction" (gains/losses) day-after-day but the magnitude and drift of the changes matters a lot as well, especially over time.
The graph you have there shows the diversified portfolio beating the other portfolio significantly during some periods and losing in others.
Correlation is just one useful tool among many toward building a diversified portfolio.
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