Two funds: Did we really diversify?
Different funds can hold the same companies. Check cumulative exposure, not just the number of funds.
Diversification is assessed across companies, sectors, countries and asset types. Two funds with similar holdings can duplicate the same exposure. Check holdings lists and weights, the data date, policy, fees, currency, distribution or accumulation and tracking differences. Diversification can reduce idiosyncratic risk but does not eliminate broad market declines. There is no single list of funds suitable for everyone.
Half the portfolio in Fund A which has 40% in a fictional company, and half in Fund B which has 20% in the same company. Total exposure to it is 50%×40% + 50%×20% = 30%.
Explain why three technology funds are not necessarily three different sources of risk.
Investor.gov · Diversification ↗Check your understanding
What is the total exposure to the company in the example?
- 60%
- 30%
- 20%
Answer and explanation
30%. Also weight the fund’s share of the portfolio and the company’s weight within each fund.
Do more funds always improve diversification?
- Yes
- No; holdings can overlap
- Yes, if the names are different
Answer and explanation
No; holdings can overlap. The number of funds alone does not indicate the actual diversification of exposures.
Continue learning
Price-to-Earnings (P/E): What is the price relative to earnings? — The price-to-earnings (P/E) ratio is the share price divided by earnings per share. It is a ratio, not a forecast and not a buy recommendation.
How does one fund unit represent a basket of stocks? — A unit in a fund gives a proportional share of a fund that holds assets; it is not one share in each company.
How do company weights change an index? — An index can weight companies by market cap, price or equal weight. A large number of companies does not guarantee balanced diversification.