Diversification is one of the first rules of reducing risk in investing. Simply put, it means following the "don't put all your eggs in one basket" principle. By spreading investments across a variety of assets the overall risk of the portfolio can be lowered.
In practice, this means you should have a basket of shares across a spread of industries and sectors, rather than a few large holdings in similar stocks. The theory is that by diversifying, your portfolio with be better able to withstand market volatility as the returns on the different shares will not be perfectly correlated.
The ASX has more than 2,000 shares available to trade, but is just a portion of the global investment universe. The New York Stock exchange offers 2,400 companies to trade, the NASDAQ more than 3,000. In the United Kingdom, the London Stock Exchange features more than 2,000 companies.
To diversify further, other asset classes such as property, bonds, and even gold or other commodities could be added to the mix. If these assets have a less than perfect correlation to your existing investments, you should reduce the risk of your portfolio even more.
The issue is how to achieve diversification on limited funds. It is just not practical to hold parcels of shares below a certain limit. Trading costs must also be taken into account.
So, with so many investment options, how can you diversify with $20,000?
Exchange traded funds (ETFs) are a great way to maximise diversifying power. Running the gamut from gold ETFs backed by physical bullion to ETFs tracking some of highest market capitalisation companies in the world, ETFs can offer both broad and specialised exposure. ETFs are traded on the stock market just like shares, and give the holder an interest in the assets of the fund, which could be gold, shares, bonds, or something else.
Australian shares
VanEck Vectors Australian Equal Weight (ASX: MVW) covers approximately 75 blue-chip companies weighted equally. The fund aims to track the MVIS Australia Equal Weight Index before management costs. Management costs are 0.35% per annum. The index includes the largest and most liquid companies on the ASX with diversification across securities and sectors. Returns over 5 years were 8.78% per annum as at 30 September.
At 30 September the fund held 86 securities and had a price-to-earnings (P/E) ratio of 17.95 with a dividend yield of 3.93%. The number one holding was Afterpay Touch Group Ltd (ASX: APT), which accounted for 1.31% of holdings. Other top 10 holdings included Iluka Resources Ltd (ASX: ILU), Goodman Group (ASX: GMG), Northern Star Resources Ltd (ASX: NST) and Santos Ltd (ASX: STO).
US Shares
iShares S&P 500 ETF (ASX: IVV) tracks the performance of the S&P 500 index (before fees and expenses) providing broad exposure to large capitalisation US stocks. Management fees are 0.04% per annum and and distributions are made quarterly. As at 30 September, the fund had provided annual returns of 10.79% over 5 years and had a P/E ratio of 20.98.
Top 10 holdings as at 30 September include Microsoft (4.27%), Apple (3.83%), Amazon (2.90%), Facebook (1.72%), Berkshire Hathaway (1.64%), JP Morgan Chase & Co (1.51%) and Proctor & Gamble (1.25%). iShares offers both hedged and unhedged versions of the ETF, with the hedged version known as iShares S&P 500 (AUD Hedged) ETF (ASX: IHVV). The hedged version minimises the impact of Australian dollar volatility on returns and has a management fee of 0.10%.
Property
VanEck Vectors Australian Property ETF (ASX: MVA) is designed to capture the performance of Australia's property market. The Fund tracks the performance of the MVIS Australia A-REITs Index, which includes the largest and most liquid real estate investment trusts. As at 30 September, 5-year returns were 9.83% per annum and the fund had net assets of $240 million.
The fund holds 12 property securities including Goodman Group (ASX: GMG), Charter Hall Group (ASX: CHC), Mirvac Group (ASX: MGR), Vicinity Centres (ASX: VCX), and Cromwell Property Group (ASX: CMW). The dividend yield of the fund was 4.55%, as at 30 September, and the P/E ratio was 15.11. Management fees are 0.35% per annum and dividends are paid twice annually.
Gold
Betashares Gold Bullion ETF – Currency Hedged (ASX: QAU) is backed by physical gold bullion held in a London vault. The fund hedges its US dollar exposure to allow for transparent exposure to the price of gold. Fund returns over the year to 30 September were 23.84%.
Betashares discloses the actual gold holdings backing the fund and value of the fund's assets daily on the fund website. Details of each gold bar including serial number, refinery, purity, weight, and year of casting are available. Units in the fund can be bought and sold on the ASX like any share, providing for far greater liquidity than physical gold. Management costs are 0.59% per annum.
Bonds
Vanguard Global Aggregate Bond Index (Hedged) ETF (ASX: VBND) provides exposure to fixed income securities issued by government entities and investment-grade corporates from around the world. The fund seeks to track the Barclays Global Aggregate Float-Adjusted and Scaled Index hedged into Australia dollars before fees, taxes and expenses. Management fees are 0.20% per annum.
Investments by the fund are predominantly rated BBB- or higher by S&P or equivalent ratings agencies. Distributions are made quarterly and the fund's weighted average coupon is 2.6%. Top 10 holdings include securities issued by the United States Treasury, Japanese Government, Federal National Mortgage Association, and republics of France and Italy. Distributions are made quarterly.
Foolish takeaway
Diversification can be achieved relatively cheaply with the aid of a few well-chosen ETFs to round out your portfolio. ETFs can provide exposure a single commodity or as many as hundreds of securities depending on your pick. With $20,000 (or even $10,000) and the ETFs listed you could gain exposure to 86 Australian stocks, more than 500 US stocks, a dozen Australian property securities, gold, and fixed income securities issued by a variety of global government and corporate issuers.
Which ETFs you pick and how much capital you allocate to each will depend on your investing style and risk tolerance. Those with lower risk tolerances may prefer to devote more funds to fixed income, gold, and property ETFs. Those with higher risk tolerances will likely prefer a heavier weighting towards shares, both international and domestic. Either way, the strategic use of ETFs provides a cost effective method of increasing the diversification of your portfolio.
