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June 8, 2016

A simple mistake ETF investors need to avoid

Time for some easy-to-use investment advice. We have written on several occasions that index funds (ETF) should be the core building blocks of your investment portfolio. ETFs allow for easy and low-cost investing.  However, not all ETF are equally suitable. If we look at the 10 most popular index funds in Germany, there are at least three that we would not recommend due to a lack of sufficient diversification.

Thou shalt not put all thy eggs in one basket

This is probably the first commandment of investing but it is astonishing how many sinners there are among investors. Why diversify? Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Since nobody has a crystall ball and nobody can 100% predict the future, it is better to be diversified across more assets than less. This is nothing new, already Salomon advised us to be cautious and diversified long ago in Ecclesiastes 11:2:

Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.

More is better

By investing in ETFs rather than individual securities, you have already taken a step in the right direction. Don’t blow it by pouring all your money into one poorly diversified ETF! But what is the right level of diversification? Academic studies show that a well diversified portfolio should have more than 100 stocks. Since it doesn’t cost materially more to have an ETF with a bigger number of holdings, it makes little sense to buy one which includes only 30 like the DAX or only 50 like the Euro Stoxx 50. But if we look at the most popular ETFs in Germany during 2015 (measured by inflow), they took 3 of the top 10 spots.

ETF 2015 - V2

People who hold undiversified portfolios, like people who buy lottery tickets, behave as gamblers since they accept higher risk without compensation in the form of higher expected returns.

ETFs on the DAX or on the Euro Stoxx 50 are not bad per se – as long as investors know what they are getting into. The companies in the DAX are heavily geared towards cyclical exporters and there is a distinct lack of technology companies as well as more quality growth sectors such as pharmaceuticals and staples. Result: 10% of the revenues of the companies in the DAX are derived from China. This is highly unrepresentative of the German economy. It was therefore no surprise that the DAX massively underperformed during the Q1 sell-off. The Euro Stoxx 50 comes with its own share of problems: 23% of its holdings are in financials and the second biggest weighting, industrials, has only 13%. Buying the Euro Stoxx 50 in many ways represents a bet on European banks – fine if that is what you are looking for but this is probably not a good idea if you target a broad European equity exposure.

What about bond ETFs? Many indices suffer from a similar problem: the higher the debt, the bigger the weighting. How crazy is that? Basically if country issues more debt and thus becomes riskier, it gets a bigger share. For example the EMBI+ index used to be about one-quarter Argentina because they had borrowed like loons.

Remember: not all ETF are created equal. You always need to carefully analyze the makeup of the holdings along with their weighting.

Portfolio optimisation 101

Our investment philosophy is to focus on what we can control. While it is outside of our control where the Dow Jones Index or the DAX will close by year-end, we can pick the right index fund with the lowest risk to achieve your personal goals. Investors should therefore avoid as their core investments ETF that are too narrowly focused such as country funds, thematic funds or other funds with a poor index construction.

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