How Many ETFs Should I Own?

Weekly Q&A: Is 5 ETFs enough to build a diversified portfolio?

I got a great question last week from Cindy B [edited for clarity]:

“Would you talk about diversification and risk when you have, hypothetically, 1 million in equity portion of your portfolio. Should an ETF portfolio of that size have more than 5 ETF’s? Do you have a higher risk if you hold, hypothetically, 20% in DGRO vs. 10% in VIG + 10% in DGRO? Is there any data on maximum % an individual ETF should be inside your equity portfolio and, separately, the % that ETF represents in your total portfolio? Lastly, what if you are very bullish on a particular area of the market and want a large % of your portfolio invested in this area, but there is only one ETF you feel confident in. Hypothetically, if you wanted 35% of your equity ETF portfolio to be invested in a managed ETF that does not track any index, like AARK, is that just flat out too much money to put into one space with one ETF? I’m a new subscriber, because you’re a really good teacher. I’m looking forward to your weekly Q&A.”

Diversification is a question that deserves more than just one post or video. Let’s break this down into multiple different posts:

• Should a portfolio of that size ($1 million) only have 5 ETFs? That’s the topic of today’s post: “How many ETFs should I own?”
• Is 20% in DGRO risker than 10% in DGRO and 10% in VIG? We’ll examine this in a later post.
• What’s the maximum percentage I should have in one ETF?
• Is 35% too much to invest in one idea or one sector?

The ETF is the Vehicle; Not the Investment

Any investment product that contains a basket of underlying investments (like an ETF, mutual fund, target-date fund) is of no importance in itself. It’s like the wrapper around the candy. In some instances, that wrapper becomes relevant. In most cases, it’s what’s inside that matters most.

To know whether a portfolio of ETFs is diversified enough, we must consider the investments inside each ETF. And if it holds that the ETF wrapper doesn’t matter, then it also holds that…

Number of ETFs You Own is Irrelevant

Academics have been telling us for years that the number of holdings we have determines our diversification. I think that logic is flawed (more on that later), but that thinking spills over into owners of ETFs, and it should not.

Since ETFs own underlying securities, the ETF itself does not add anything to your diversification. Owning two S&P 500 Index funds, for example, makes no difference to your diversification because both ETFs hold the same 500 stocks.

To illustrate further, let’s consider two scenarios. In scenario #1, let’s say you own 100 different ETFs. In scenario #2, you own one ETF and have everything in that. Which is more diversified? The correct answer is: I don’t know. There is not enough information.

Let’s add some information here, and then we’ll talk. In scenario #1, you own 100 different ETFs, with each ETF owning 100% of one security. Let’s say scenario #2 you own VTI, which has 3,529 holdings. Now, which is more diversified?

The answer then is scenario #2 would be more diversified.

In fact, in this example, you would be less diversified owning two ETFs than you would to own just one.

If you owned 50% of ETF #1 (1 holding) and 50% of ETF #2 (with 3,529 holdings), your ending portfolio would be half invested in one security. You would be far more diversified owning just ETF #2.

We can expand that logic even more. The most diversified ETF of all is the Total World Market Index, which contains approximately 8,000 different stocks across all countries. Therefore, a Total World Market Index ETF (like VT) would be as diversified as you could get within stocks. Any ETF you added to that portfolio would make it more concentrated and, therefore, less diverse. Even though your account statement would only show 1 ETF, you would be as diversified as you could get.

Is buying every stock there is the ultimate path to diversifying your risk? If the number of stocks represents diversification, then yes, that would be the best way to go.

Yet, is owning the largest number of stocks the appropriate way to think about diversification?

I don’t think so.

Diversification is Not Owning a Large # of Securities

Academics have us all backward on this. We’ve begun to associate the number of securities as an indicator of safety. By owning 1,000 stocks, we feel more secure than if we only owned 100. They tell us that our “risk” is diversified.

Where that thinking falls short is in two ways:

The number of companies may not reflect actual underlying risks.

Consider a situation where you have the choice to own Portfolio A, or Portfolio B. Portfolio A owns ten stocks - one from each major sector in the US economy. Portfolio B owns 10,000 companies all from the same industry.

Which of these portfolios is more “diversified”? I’d argue that Portfolio A is dramatically more diversified. Why? Because it has a diversity of exposures. Coca-Cola sales have little relationship with rail traffic, so KO and UNP will act differently in the same environment. Visa and Verizon are in different businesses, so they won’t always move in the same direction. If one of those ten companies goes under, the other nine should hold up OK.

In Portfolio B, you have 10,000 different stocks - but they all have very similar risk exposures. If you owned 10,000 airline stocks in January 2020, your risks were not that much lower than they would have been if you would have only owned 10. COVID-19 hugely impacted every stock in the airline industry. It would have been better to own just one airline stock and one unrelated stock (like a consumer staple or Utility or something).

I’m not necessarily arguing that fewer stocks are better than more. The most important thing is exposure to different variables so that the whole portfolio is not subject to the same risks.

Not all companies are created equal.

Would you rather eat 1/10th of a diversified basket of candy? Or would you rather eat one of only your favorites?

Proponents of broad diversification argue that it’s less risky to own a small piece of everything. I’d say that it’s better to own a large part of only the best.

By investing in every single stock, you are effectively eating every piece of candy - even the bad ones. You’re saying that every company is worth an investment. In reality, there are only a small fraction of outstanding businesses out there. And every $1 you invest in a low-quality business, that’s $1 you can’t invest in a quality one.

Imagine all of the restaurants in your hometown or county. Let’s say you had the choice to own either $50,000 each in 10 restaurants vs. $10,000 each in all 50. Which would you choose?

I’d choose the former, so long as you were able to own only the best ten. How you define “best” is up for debate, but I’d personally look for things like: positive profits each year (many restaurants don’t make money) low debt relative to their profits honest and ethical management.

By owning only the ten best, you would do far better than owning all 50. It’s the substance of the underlying investments that matter more than the quantity of them.

Weighting Matters More than Number

One other item to consider is that even the most diverse Index (measured by # of stocks) may not be all that diverse. The Nasdaq 100 index, for example, is comprised of 100 stocks. Yet eight out of 100 make up 50% of the portfolio.1

Why? QQQ is market-cap-weighted, which means the largest companies are weighted more than smaller ones. AAPL is the largest company in the Nasdaq, so it gets the largest weighting (over 13%).2

Said another way, 8 of the stocks in QQQ matter more for your future returns than the other 92 combined. Technology makes up over 50% of QQQ, which brings the diversification further in question. You could argue that a portfolio of, say, ten equally weighted stocks in different sectors would be more diversified than QQQ - even though it has more stocks. The weighting makes all the difference.

Some may argue that an equal-weighted portfolio is more diversified than a market-cap weighted portfolio, and there would be some legitimate argument to that. In VTI, for example, the Technology sector currently makes up 33.4% of the Index. Apple, Microsoft, Amazon, Facebook, and Alphabet collectively make up 18.5% of the ETF.3 In the equal weight S&P 500 portfolio, on the other hand, each of these stocks would only be 0.2% on each rebalance date. So 1% would be in those five stocks, whereas nearly 20% was in those five in the market-cap-weighted ETF.

3 Take Aways

So far, I’ve just been skating around Cindy’s question, but it’s essential to first understand the basic foundational principles of diversification. Only then can we adequately address particular applications of it in terms of ETFs or any other investments.

Let’s now look at parts of Cindy’s question that I think we answered here:

1. Would it be appropriate for her to invest $1 million across 5 ETFs? I don’t know; that depends on the ETFs. Cindy could be justified to invest 100% of her $1 million in one ETF or entirely inappropriate to invest in a mix of 100 ETFs. The point is that the number of ETFs isn’t what matters. It’s what the underlying ETFs own that does.
2. What’s the appropriate number of ETFs? It could be as little as one. If you invest in more than ten, the benefits of owning those ETFs may get pretty diluted. For example, if you owned 10% in 10 different dividend ETFs, you probably have broad exposure to nearly every dividend stock. If that’s the case, then you might as well buy 100% of an ETF that covers the entire dividend space. The additional ETFs could be “diworsifying” than just buying a core dividend ETF would be.
3. Is it appropriate to invest 35% in ARKK? That depends on what she thinks about the future of that ETF’s investments. I know very little about it, so I shouldn’t comment on specifics. I will say that everyone should follow a strategy they have conviction in and what fits their specific goals. If you don’t believe in it, then you don’t have enough confidence to own it. And if you don’t understand it, then you won’t stick with it during hard times. There are no hard-and-fast rules about what’s “too much” of an ETF.

If you have any questions or comments, reply to this email. I’d love to hear from you!

Have a great day, everyone!
Nathan

1. “QQQ: Invesco QQQ Trust.” ETF.com. https://www.etf.com/QQQ#overview. Accessed on October 28, 2020. ↩
2. “QQQ: Invesco QQQ Trust.” ETF.com. https://www.etf.com/QQQ#overview. Accessed on October 28, 2020. ↩
3. “Vanguard Total Stock Market Index (VTI).” ETF.com, MSCI. Data provided by Factset. https://www.etf.com/VTI#overview ↩