Diversification: How much is too much?

Human nature and behavioral biases affect nearly every aspect of life. One of those common tendencies is to tell ourselves, “If a little bit is good, then more is better.”

With the proliferation of modern portfolio theory (MPT), diversification has become a bedrock of portfolio management, a seemingly foolproof strategy for mitigating risk. Generally, the objective of diversification is to lower portfolio volatility and increase risk-adjusted returns. However, actual results may surprise investors.

Studies show that if active managers would have invested solely in their highest-conviction ideas, the resulting concentrated portfolios would have achieved higher absolute and risk-adjusted returns (see chart below).

So, what is optimal?

The key to achieving an efficiently diversified portfolio is to invest in assets with low correlation, meaning the assets respond differently from one another in a variety of scenarios. 

True diversification can help potentially reduce portfolio volatility. However, problems can occur when investors try to achieve diversification by simply adding more holdings. Many experts believe the benefits of diversification start to diminish at around 20-30 securities. By adding more securities, investors may dilute the impact of the highest-conviction ideas without an equivalent decrease in portfolio volatility.

We’ll use the example of a simple portfolio consisting of four mutual funds representing the four corners of the Morningstar style box: large growth, large value, small growth, and small value. If each fund were to own 100 stocks, then the overall portfolio would consist of 400 stocks – nearly eight times the number of holdings needed to diversify a portfolio.  In some cases, an investor may be paying active management fees, but the portfolio could end up looking a lot like the overall stock market. A potentially more effective use of diversification would be to choose a group of concentrated, highly active funds whose portfolio characteristics differ from one another – combining diversified asset allocation with high-conviction portfolios.

What can investors do?

Investors may want to consider a more focused approach to equity investing.  

Macquarie’s large-cap growth platform can help you access more focused, or concentrated, equity strategies. For example, Macquarie Focused Large Growth ETF (Ticker: LRGG), uses a quality-first approach to investing in large-cap growth equities. We aim to give clients exposure to our highest-conviction ideas by owning 15-25 companies that we believe have the greatest competitive advantages in our investable universe. The combination of optimal diversification and a focus on quality business models gives investors the potential to truly benefit from active investment management.

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Past performance does not guarantee future results.

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Investing in any exchange-traded fund involves the risk that you may lose part or all of the money you invest. Over time, the value of your investment in the Fund will increase and decrease according to changes in the value of the securities in the Fund’s portfolio. An investment in the Fund may not be appropriate for all investors.

Diversification may not protect against market risk and cannot assure a profit.

Modern portfolio theory (MPT) assumes investors are risk-averse and are seeking a less risky portfolio at a given level of return.

Sharpe ratio measures the relationship between reward and risk in an investment strategy. The higher the ratio, the greater the investment return relative to the amount of risk taken.

The Fund’s principal risks include but are not limited to the following:

Market risk is the risk that all or a majority of the securities in a certain market — like the stock market or bond market — will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.

Growth stocks reflect projections of future earnings and revenue. These prices may rise or fall dramatically depending on whether those projections are met. These companies’ stock prices may be more volatile, particularly over the short term.

Governments or regulatory authorities may take actions that could adversely affect various sectors of the securities markets and affect fund performance.

Large-capitalization companies tend to be less volatile than companies with smaller market capitalizations. This potentially lower risk means that the Fund's share price may not rise as much as the share prices of funds that focus on smaller capitalization companies.

The possibility that a single security’s increase or decrease in value may have a greater impact on a fund’s value and total return because the fund may hold larger positions in fewer securities than other funds. In addition, a fund that holds a limited number of securities may be more volatile than those funds that hold a greater number of securities.

A nondiversified fund has the flexibility to invest as much as 50% of its assets in as few as two issuers with no single issuer accounting for more than 25% of the fund. The remaining 50% of its assets must be diversified so that no more than 5% of its assets are invested in the securities of a single issuer. Because a nondiversified fund may invest its assets in fewer issuers, the value of its shares may increase or decrease more rapidly than if it were fully diversified.

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The Fund is an ETF, and, as a result of an ETF’s structure, it is exposed to the following risks: “Authorized participants, market makers and liquidity providers concentration risk,” “Secondary Market Trading Risk” and “Shares may trade at prices other than NAV risk.”

Only authorized participants (“APs”) may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of financial institutions that are institutional investors and may act as APs. In addition, there may be a limited number of market makers and/or liquidity providers in the marketplace, and they have no obligation to submit creation or redemption orders. To the extent either of the following events occur, the Fund’s shares may trade at a material discount to net asset value (“NAV”) and possibly face delisting: (i) APs exit the business or otherwise become unable to process creation and/or redemption orders and no other APs step forward to perform these services, or (ii) market makers and/or liquidity providers exit the business or significantly reduce their business activities and no other entities step forward to perform their functions. These events, among others, may lead to the Fund’s shares trading at a premium or discount to NAV. A diminished market for an ETF's shares substantially increases the risk that a shareholder may pay considerably more or receive significantly less than the underlying value of the ETF shares bought or sold.

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Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Any applicable brokerage commissions will reduce returns.

The Fund is a newly organized, diversified management investment company with no operating history. In addition, there can be no assurance that the Fund will grow to, or maintain, an economically viable size, in which case the Board of Trustees of the Trust (the “Board") may determine to liquidate the Fund.

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