What are diversified ETFs and how are they different to “normal” ETFs?

Diversified ETFs and "normal" ETFs (which might focus on a specific sector, asset class, or geographical area) both operate on the fundamental idea of tracking an underlying index and being tradeable on share markets. The key difference lies in the scope of their investment objectives and holdings.

Note: “ETF” stands for exchange-traded fund. If you’re new to investing and aren’t sure what an ETF is, read this article first: What is an ETF? .

Diversified ETFs

A diversified ETF is a single investment fund that spreads money across multiple asset types or sectors. Key factors worth knowing about include:

• Asset class diversity : A diversified ETF doesn't just stick to one type of asset like shares. It often combines shares, bonds, commodities, and sometimes even real estate investments into one package.
• Sector balance : These ETFs try not to lean too heavily on one business sector. Instead of just having tech or energy shares, for instance, a diversified ETF will aim to have a mix, such as tech, healthcare, utilities, and retail.
• Global exposure : Many diversified ETFs don't restrict themselves to a single country's assets. They often include international shares and bonds to provide a global flavour to your investments.
• Risk management : Because of their diverse nature, these ETFs are generally considered to have built-in risk management. If one sector or asset class is performing poorly, the other elements can potentially offset the impact.
• Built for the long term : Diversified ETFs can often align with long-term investing strategies because they aim for growth while balancing risk, which can be especially beneficial over a longer time horizon.

Normal ETFs

An ETF is a fund that tracks a specific index, sector, or asset, trading like a stock. Key differences between “normal” ETFs and diversified ETFs:

• Niche focus : A normal ETF usually concentrates on a specific asset class (like shares or bonds), sector (like technology or healthcare), or geography (like the U.S. or emerging markets).
• Risk profile : Because of this focus, a normal ETF might have higher volatility. If the tech sector suffers, a tech-focused ETF will likely take a hit, without any other sectors present to balance it out.
• Specified goals : These ETFs often aim to track the performance of a specific index or meet particular investment objectives, such as income generation through dividend-paying shares.
• Short-term or long-term : Depending on their focus, normal ETFs can be used for both short-term trading opportunities or as a part of a long-term investment strategy.
• Lack of internal diversification : Usually, a normal ETF does provide some level of diversification by holding multiple assets within its chosen focus area. However, it doesn't offer the broad diversification across different asset classes, sectors, and geographies that a diversified ETF does.

Diversified ETFs vs “normal” ETFs: the summary

"Normal" ETFs aim to replicate the performance of a specific index, such as the S&P 500 for large-cap U.S. shares. These ETFs are specialised and may not provide broad diversification across various asset classes or sectors.

In contrast, diversified ETFs aim to provide broad-based exposure to multiple sectors, asset classes, and sometimes geographical regions. For example, a diversified ETF might include shares, bonds, commodities, and international equities all in one fund. The idea is to offer a "one-stop-shop" for diversification, reducing the investor's risk associated with any single asset class, sector, or geographic region.

In short, both types of ETFs can offer the advantages of easy trading and lower costs compared to traditional mutual funds. However, diversified ETFs are designed to offer a more balanced, risk-mitigated portfolio right out of the gate.

What are the pros and cons of investing in diversified ETFs?

Now that we’ve covered the basics, let’s take a deeper dive into their pros and cons!

Benefits of investing in diversified ETFs

• Broad exposure with one purchase : As we mentioned earlier, diversified ETFs provide exposure to a mix of asset classes, sectors, or geographies. This allows investors to achieve wide-ranging diversification with just one purchase. In contrast, to achieve similar diversification with normal ETFs, you'd need to invest in multiple.
• Risk management : The inherent diversity of these funds can potentially smooth out market volatility. If one component (like a specific sector or geography) underperforms, other components might offset potential losses. A normal ETF, with its more concentrated exposure, might not offer the same cushion against sector-specific or region-specific downturns.
• Simplified portfolio maintenance : Diversified ETFs usually rebalance automatically to maintain a particular asset allocation or strategy. With normal ETFs, achieving and maintaining a diversified allocation requires manual rebalancing on most brokerage platforms ( but not Pearler! ), which can be more time-consuming and potentially costly.
• Potential cost savings : Investing in a diversified ETF can sometimes be more cost-effective than investing in multiple normal ETFs. One transaction fee for a diversified ETF purchase could be cheaper than multiple transaction fees for several normal ETFs.
• Diversification across market conditions : During specific market conditions, certain sectors or regions might outperform, while others lag. Diversified ETFs can ensure that you have exposure to various market segments, which can be beneficial in unpredictable market scenarios.
• Flexibility in achieving goals : Whether an investor is aiming for growth, income, or a combination, diversified ETFs come in varieties that can cater to these varied goals. This can provide more flexibility than if you’re tied to the performance of a specific sector or region with a normal ETF.

Downsides of Investing in Diversified ETFs

• Limited upside potential : Since diversified ETFs spread investments across various asset classes, they will not fully capitalise on a specific booming sector or strong-performing asset.
• Less control : Investors have limited ability to adjust the asset allocation of a diversified ETF. In contrast, with individual ETFs, they can customise their portfolio based on specific preferences or beliefs about market performance.
• Fee stacking : While diversified ETFs typically have a single management fee, the underlying assets may also come with fees. This can sometimes result in slightly higher total fees compared to a single, specialised ETF. To prepare for this, always research a diversified ETF’s fees before you buy.
• Lack of focus : Specialised ETFs often target specific sectors, regions, or investment strategies. Investors with a bullish view on a particular area might find diversified ETFs too broad for their taste.
• Redundancy : If an investor holds multiple diversified ETFs or a mix of diversified and specialised ETFs, there could be overlapping holdings, leading to unintentional concentration in certain areas.
• Reactivity to market trends : While specialised ETFs can quickly adapt to market changes by rebalancing or focusing on trending sectors, diversified ETFs are generally more static in their allocations, potentially missing out on short-term trends.

Diversified ETF pros & cons summary

Diversified ETFs give investors exposure to various assets or sectors through one purchase. This approach helps mitigate risks from any sector's poor performance. They are often more cost-effective and straightforward, making them appealing for beginners and experienced investors who want a hands-off investment. They also cater to different risk levels, from conservative to aggressive.

On the flip side, their broad nature caps the potential upside that making big bets on specific sectors provides. There's also limited control over asset allocations, and if an investor holds multiple ETFs, overlapping holdings can easily occur.

Who should invest in Diversified ETFs and who should not?

Diversified ETFs can be an excellent option for long-term investors. They can provide a simple way to invest incremental amounts in diversified portfolios for the long term.

They usually aren’t great options for short-term investors as they typically skew towards growth assets, which can be volatile over the short-term.

Some long-term investors have historically used diversified ETFs as a one-stop shop, whereby they’re the only investment they hold and/or accumulate. This has been a popular strategy for beginners and experienced investors alike. The only requirement is to set and forget – and we even have an Automate option for that.

Alternatively, other long-term investors use a Diversified ETF as the core holding in their portfolio. Then, they make strategic investments in select shares or ETFs where they want to overweight their portfolio. Reasons for going overweight on a particular sector or stock vary, but the two most common are believing they will outperform or wanting to financially support a particular cause or company. Core/satellite ratios vary, but 80/20 and 90/10 are two of the most common.

Important note: almost all core/satellite strategies underperform against a comparable 100% diversified ETF strategy over the long term.

Australia’s most popular diversified ETFs

Below is a list of the most popular Diversified ETFs on Pearler, in order:

1. Vanguard Diversified High Growth Index ETF (VDHG)
2. Betashares Diversified All Growth ETF (DHHF)
3. BetaShares Ethical Diversified High Growth ETF (DZZF)
4. Vanguard Diversified Growth Index ETF (VDGR)
5. Vanguard Diversified Balanced Index ETF (VDBA)
6. BetaShares Ethical Diversified Growth ETF (DGGF)
7. BetaShares Ethical Diversified Balanced ETF (DBBF)
8. Vanguard Diversified Conservative Index ETF (VDCO)

If you’re interested in investing in a diversified ETF, this list is a great place to start.

If you need help selecting a diversified ETF check out: How to choose the right ETF for me .

Happy investing!

Kurt