What are well diversified emerging market funds

The ETF trap or the myth of the diversified portfolio

ETF portfolios are trendy; a combination of an MSCI World ETF and an MSCI Emerging Markets ETF is often touted as a solid mix with sufficient diversification. Unfortunately, those who follow this or similar advice run a very high risk without being aware of it.

A well diversified portfolio should meet two criteria. On the one hand, it should deliver a solid return that is as constant as possible. Second, it is supposed to cushion price falls so that strong market slumps do not end in a financial catastrophe. It is unfortunately very difficult to meet both criteria in practice; and most ETF strategies simply fail to do this.

Together over the cliff

Based on the often similar recommendations and online tutorials (such as homemade-finance or FAZ), we have built up a globally diversified portfolio of the following ETFs:

This means that we are internationally positioned, with Europe, the USA, emerging countries and a global component in our depot. Our portfolio is broadly diversified internationally, we are satisfied and confident. But rightly?

Globalization as a risk

A well-founded analysis shows that the prices of the ETFs selected for our portfolio behave very similarly. In particular, the ETF classics MSCI World, MSCI Emerging Markets, DAX and Dow Jones show a strong correlation in their historical price developments - in other words, they usually rise and fall together.

The individual ETFs are consistently strongly correlated with our portfolio. Only a value below 0.5 would mean real diversification of the portfolio. Source: Rentablo depot analysis.

Why is this so? We suspect the origin in the index composition. The large and popular indices mostly consist of large international companies. They either have a large part of their business in Europe, the USA and China, or they are heavily dependent on capital flows there. In addition, there are of course many cyclical companies in all indices that are equally affected by an economic upswing or downturn. A large international company such as BASF is equally affected by an economic downturn in the USA, Europe or China.

A simple mix of standard ETFs does not result in risk diversification

We are now comparing the risk and return of our “diversified” portfolio with a portfolio that only consists of the iShares Dow Jones Industrial Average (DE0006289390).

Return and risk for our diversified portfolio:

Mutual dependencies (correlation) and historical risk of an international ETF portfolio. Source: Rentablo depot analysis.

Risk and return for the “Dow Jones” portfolio:

Historical risk of an ETF portfolio consisting only of the iShares Dow Jones Industrial Average. The mutual dependency is 1 in this case, since we only have one security in the portfolio. Source: Rentablo depot analysis.

We see: the diversified portfolio shows no improvement in historical risk, and the mutual dependency of the individual ETFs is also very high. Unfortunately, our ETF strategy has not given us any risk diversification.

Adding a gold ETF will drastically reduce interdependence

We have now learned that the often propagated “simple” strategies are not effective. So we are specifically looking for an ETF that is anticorrelated (oppositely) to our portfolio. We find what we are looking for at Van Eck Gold Miners ETF (US92189F1066). The inclusion of this ETF in the portfolio immediately leads to a drastic reduction in mutual dependencies and should therefore make our portfolio more “crisis-proof”.

Bonds in the portfolio

One could argue that it is usually recommended to hold around 30% of the portfolio in bonds; and that this would already be enough risk protection.

However, one should bear in mind that the return on the portfolio normally comes from the equity component (and bond prices boom, especially when interest rates fall). However, a good long-term return stands or falls with good diversification and the ability of the portfolio to at least preserve its assets even in weak times. Once the equity component has fallen by 30, 40%, it is very difficult to make up for this in the medium term. In our annual outlook for 2019, we show that such slumps are quite realistic and that the subsequent recovery can easily take 10 years.

Bonds risk factor

It is also often overlooked that we are currently not living in normal economic times. In fact, we currently see bonds as one of the riskier forms of investment. If interest rates rise again, many bonds are likely to post sharp price losses. Especially with a bond yield of 1%, an increase in interest rates to only 2% must lead to strong price drops.
On the other hand, if the economy collapses sharply, there will be no monetary control options. Company and state bankruptcies will be the result and consequently the default of many bonds currently considered to be “crisis-proof”.

The value of bond portfolios rises when interest rates fall and falls when interest rates rise. Unfortunately, equity portfolios usually also fall when interest rates rise, as these increase the cost of capital and thus reduce corporate profits. Source: justETF.

So what to do

If you want to put together a long-term stable ETF portfolio, you shouldn't rely on "simple" advice. Instead, investors should make sure that their ETF portfolio is put together in such a way that dependencies in the portfolio are balanced out. This can be done by spreading across industries, including precious metal ETFs, or adding an actively managed component with a good hedging strategy.

In any case, investors should use freely available tools such as the Rentablo depot analysis or sample portfolios from EXtra-Magazin or from justETF in order not to unintentionally take high risks through wrong fund selection.


Picture by Flickr user Paul Hudson under CC-License 2.0