ETFs – a short summary

An ETF, or Exchange-Traded Fund , is a type of investment fund that holds a collection of assets like shares, bonds, or commodities. It's traded on stock exchanges, much like individual shares. Yes, ETFs have built-in diversification, provided in the following two key principles:

1. Multiple assets: An ETF isn't just one share or bond ; it's a basket of different ones. This means when you buy a share of an ETF, you're actually buying all the assets it holds.
2. Varied sectors and industries: Many ETFs hold assets from a range of sectors and industries. So, instead of trying to pick winning shares in different sectors, you get a diversified portfolio through a single investment.

You can think of an ETF like a shopping basket filled with various items, such as shares or bonds. When you buy this basket, you’re not relying on the performance of just one item; instead, you benefit from the collective performance of all the items in the basket. This spreads out your risk and is the essence of diversification.

So, if an ETF is diversified by definition, what then is a diversified ETF? And how is it different to other ETFs?

Introducing diversified ETFs

A diversified ETF is a type of Exchange-Traded Fund that provides a complete, diversified portfolio in a single investment. They are also known as “all-in-one ETFs”. These ETFs are designed to offer a balanced mix of shares, bonds, and other asset classes, and they often follow a specific asset allocation strategy. The four key features that differentiate a diversified ETF from other ETFs are:

1. Broad market exposure: Diversified ETFs often track broad market indices or have holdings across numerous sectors and industries. This contrasts with more focused ETFs, which might track a specific sector, industry, or even a single commodity.
2. Geographical diversification: Some diversified ETFs offer exposure to global markets, including developed and emerging markets . This geographical spread can protect against region-specific economic downturns, which is a level of diversification not typically found in ETFs focusing on a single country or region.
3. Asset class diversification: Diversified ETFs may include different types of assets like shares, bonds, real estate, and commodities. In contrast, other ETFs might focus exclusively on one type of asset, such as share ETFs or bond ETFs.
4. Automatic rebalancing: These ETFs are often automatically rebalanced to maintain a consistent asset allocation over time. This means the ETF adjusts its holdings to ensure that the portfolio stays in line with its intended risk and investment strategy, a convenience not typically found in more traditional ETFs.

In contrast to other ETFs, which might focus on a specific sector, region, or asset class, diversified ETFs aim to provide a broad, diversified investment solution. They are a one-stop-shop for investors, combining diversification, simplicity, and cost-effectiveness, intended for those seeking a straightforward, long-term investment strategy .

In summary, while all ETFs offer some level of diversification by nature, a diversified ETF takes this a step further by spreading investments across a wider range of assets, sectors, or geographies. This broad exposure can potentially make them more resilient to market volatility compared to ETFs that focus on a specific sector, region, or asset class, and they can offer greater investment management simplicity.

Diversified ETF or “roll-your-own” (multiple ETFs) approach

For long-term investors, two popular strategies involve using an all-in-one diversified ETF approach; or the "roll your own" approach, where you manage multiple ETFs yourself. Each has its pros and cons:

All-in-one diversified ETF approach

Pros:

1. Simplicity: This is a one-stop solution. You invest in one ETF, and it handles diversification for you across various asset classes.

2. Automatic rebalancing: These ETFs are often rebalanced automatically, maintaining your intended asset allocation without your intervention.

3. Cost-effective: Since you're buying only one product, transaction costs are typically lower. Also, the internal expense ratios can be competitive.

4. Intended for passive investors: This approach is popular with those who prefer a "set and forget" investment strategy.

Cons:

1. Limited customisation: You have to accept the ETF's predefined asset mix, which might not align perfectly with your individual goals or risk tolerance.

2. Lack of control: Investors have no say in the specific holdings of the ETF.

Roll-your-own (multiple ETFs) approach

Pros:

1. Customisation: You can tailor your portfolio to your specific investment goals, risk tolerance, and preferences.

2. Control: You choose exactly which ETFs to include, offering more control over where your money is invested.

3. Adaptability: You can easily adjust your portfolio's composition in response to changing market conditions or personal circumstances.

Cons:

1. Complexity: Managing multiple ETFs requires more time and knowledge. You need to research and select each ETF and monitor their performance.

2. Risk of poor asset allocation: Without proper knowledge, you might create an unbalanced portfolio that doesn't align well with your investment objectives.

In summary, the all-in-one diversified ETF approach offers simplicity and ease, suited for those who prefer a passive investment strategy. On the other hand, the roll-your-own strategy provides more control and customisation but requires more time, knowledge, and potentially higher costs. The choice between the two largely depends on your investment knowledge, the time you're willing to commit to managing your investments, and your personal preferences in terms of control and customisation.

If you’re interested in going deeper on this comparison, check out: Diversified ETFs or DIY .

If you’re interested in going deeper on Diversified ETFs, check out: The ultimate guide to diversified ETFs for Australians .

Happy investing!