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Diversification is as essential to portfolios today as it has ever been. Sound investing requires that a portfolio be sufficiently diverse to ensure that instability in one area can be balanced out in another. For financial advisors, a key part of the job is to help clients ensure their clients are properly diversified, regardless of the size of their accounts.
When it comes to real-world portfolio construction, exchange-traded funds (ETFs) can make broad diversification across asset classes, sectors, geographies, and strategies both accessible and cost-effective. Still, many clients may need support from their advisors to include ETFs in their portfolios in the right way.
Key Takeaways
- ETFs make it easier to diversify across asset classes, sectors, and geographies.
- Thematic and factor-based ETFs add precision to diversification efforts.
- Advisors should strike a balance between simplicity and strategic complexity.
- Global diversification and alternative asset ETFs are increasingly client-relevant.
- Monitoring overlap and correlation is essential—even with diversified holdings.
1. Use Broad-Market ETFs To Cover Core Exposures
Broad-market ETFs, such as those tracking the total market or the S&P 500 index or using aggregate bond strategies, are often an excellent starting point toward building a diversified portfolio.
Mary Beth Storjohann, a certified financial planner and founder of Allora Wealth, notes that broad-market funds “can provide clients with cost-effective exposure to the overall market without having to pick winners.” As clients face transitions in careers, caregiving needs, retirement, and so on, “these core holdings can offer a steady foundation that can be built around as life evolves.”
2. Expand Across Asset Classes with Fixed Income, REIT, and Commodity ETFs
If retail investors know much about ETFs at all, they imagine funds trading baskets of stocks grouped around particular indexes, strategies, or themes. However, the ETF universe is much broader—and this can be an excellent way to encourage clients to diversify their investments. Bond ETFs, for example, hold collections of bonds with a similar degree of variety to stock-based funds. Other ETFs are structured around real estate investment trusts (REITs), while still others focus on commodities or commodity futures.
By expanding beyond the main part of the ETF world—most funds of this kind do focus on stocks—investors can broaden their investments with non-equity exposure, including bonds, real estate, and commodities, all while maintaining the simplicity and efficiency of ETF holdings.
3. Add Global and Emerging Markets Exposure
“Global and emerging markets ETFs open the door to long-term growth opportunities and economic shifts clients may not otherwise access,” Storjohann said, thanks to their exposure to wider geographies. She added that “markets move on different cycles, and tapping into global growth provides a valuable diversification opportunity” while mitigating country- or region-specific risk.
Global diversification can also be essential for a strong portfolio due to rapid shifts in the geopolitical landscape, a softening of the U.S. dollar, and other factors.
4. Layer in Sector or Thematic ETFs for Targeted Diversification
Broad-based funds, whether domestic or international, provide an excellent foundation of diversification in a portfolio and can be a great plan for individuals without particular expertise in or time to focus on investing. With a financial advisor’s help, retail investors can also use ETFs for targeted diversification in a bid to play market cycles or respond to a variety of economic drivers.
Some ETFs include highly complex themes, but targeted diversification is possible without venturing too far from broad funds. Sector-specific ETFs can be a great way to tilt toward a particular group of stocks when those sectors—say healthcare or technology—are outperforming. Thematic funds, which focus on various areas such as clean energy, AI, crypto, and more, may also help achieve diversification.
5. Introduce Factor-Based or Smart Beta ETFs
Smart beta ETFs provide an added layer of complexity with a mix of passive and active management. These funds follow an index but impose additional rules to select stocks from within that index based on different factors—value, momentum, quality, size, and so on.
Dean Lyulkin, co-CEO and Managing Director of Bank of Cardiff, told Investopedia that smart beta funds “might overweight the cheapest 30% of stocks or those with the highest recent returns” to make a specific, targeted strategy. Lyulkin added that “smart beta ETFs usually make sense only for long-term investors with very large portfolios” in which a “small positive delta in return or tax savings can move the needle.”
Tip
Advisors can offer these products to clients with smaller accounts as a way of tailoring exposure to specific goals.
6. Explore Alternatives Through ETF Wrappers
For more adventurous clients or those with a higher risk tolerance, ETFs can also be used to access alternative investments such as infrastructure, private credit proxies, or managed futures. Specialized funds focus on all of these investments—or on proxies for them—when direct investment is not possible.
However, they can cause a portfolio to shift away from a traditional 60/40 stock/bond allocation. For some clients, however, diversification in this way may be an important goal.
7. Manage Overlap and Correlation Risks
Lyulkin cautioned that advisors should watch out for overlap, noting that factor ETFs in particular may lead to “hidden concentrations.” “Factors that look uncorrelated in calm periods often start moving in lockstep” amid a downturn, which can erode diversification, he said. To counter this, “diligent advisors must run regular correlation analyses” and “stress-test allocations under various market scenarios.”
How Many ETFs Does a Client Need for a Truly Diversified Portfolio?
There is no single number of ETFs that will suit each client. When crafting a diversified portfolio via ETFs, consider establishing a core with funds focused on U.S. or international stocks or bonds. Additional diversification may come from funds focused on REITs, commodities, or specialized strategies like factor, sector, or thematic ETFs.
How Do I Assess Any Potential Overlap Among ETF Holdings?
One of the most efficient ways to determine overlap among multiple ETFs is with a dedicated app, such as the ETF Research Center’s Fund Overlap tool. Another approach is to manually compare the holdings of two or more ETFs, considering not only which holdings overlap but also their relative weights within the portfolios, as well as the broader degree of geographic, market capitalization, sector focus, and so on.
What’s the Difference Between Diversification By Sector vs. Geography?
Diversification in a portfolio can mean many things, and sector and geography are two key factors to consider. Diversification by sector may be thought of as adequate distribution of a portfolio across the 11 GICS sectors or, on a more granular level, across individual industries.
Diversification by geography can be on a country-by-country basis or on a broader, regional basis. Two funds may have portfolios that are geographically diversified from one another but aren’t diversified by sector, or vice versa.
The Bottom Line
ETFs are known for grouping baskets of securities into neat packages, providing ready-made diversification for investors. While this is mostly true, financial advisors may have significant work to do to ensure that their clients’ ETF-based portfolios are truly diversified.
Consider the balance among broad-market, fixed income, REIT, commodity, global, smart beta, factor, and other types of ETFs when assisting a client with portfolio construction. Beware of overlap and correlation risk, and strive for a balance between the simplicity of portfolio management and the complexity of portfolio composition to cater to each client’s specific needs, goals, and risk tolerance.
