ETF essentials ยท 2 minute read
Diversification: does an ETF spread my risk?
The short answer
Diversification means spreading your money across different companies, countries and sectors. It can reduce the impact of one investment performing badly. It cannot prevent the value of your investment from falling.
Why it matters
An ETF may give you exposure to many investments in one transaction. That can spread risk more widely than buying shares in only a few companies.
But the number of holdings is only part of the story. An ETF holding 1,500 companies could still be heavily weighted towards the United States, a particular sector or a small group of very large companies.
Diversification can be considered at several levels:
- Companies: how many companies are included?
- Countries: where are those companies based?
- Sectors: do industries such as technology or finance dominate?
- Holdings: how much is invested in the ten largest companies?
A simple example
Imagine three ETFs:
- A global ETF holding companies across many countries and sectors
- An S&P 500 ETF focused on large US companies
- A technology ETF focused on one sector
All three may be useful for different purposes, but they do not provide the same diversification. Owning all three may also create more overlap than you expect, because large US technology companies may appear in each of them.
What to check
- How many holdings does the ETF have?
- Which countries and sectors have the largest weights?
- What percentage is invested in the ten largest holdings?
- Does it overlap with another ETF you already own?
Key term explained
Concentration means that a large share of an ETF is invested in a relatively small number of companies, countries or sectors.
Diversification reduces some risks. It does not remove market risk: a broad global ETF can still fall when markets fall.