Should index investors diversify as well?

Index investing is suitable for almost everyone because once an automated investment portfolio takes care of itself. But is it also worthwhile for an index investor to diversify? I answer this question on his blog.

Since the beginning of the investment of my career, I’ve been a fan of index investing and advocate. I am talking about index investing, especially for people who could not be less interested in investing, for whom investing maybe 20 euros a month and for whom money talk is foreign, intrusive, and boring.

Index ranking when it fits almost everyone regardless of portfolio size and life situation! Once the automation of placement is taken care of, you no longer have to bother with a portfolio and placement. It doesn’t matter if you are a multimillionaire or a penitentiary student who earned his or her first salary, ETFs can be used to build a portfolio that is just right for your needs.

How to choose an ETF?

  1. Select where you want to invest.

Do you want to choose the widest possible index that covers all companies in all markets, a specific geographic location, or perhaps a specific industry or megatrend? Do you want all the companies in the whole market, or should the companies be pruned on some principle?

  1. Check the expenses.

In ETFs, the management fee can be as high as one-hundredth of a percent, while in actively managed funds it is not uncommon for the fee to be 1-3%. The cost has a huge impact in the long run, so in this case, exact staring at the decimals bears fruit. An ETF must have a good basis if it has to shell out more than half a percent of its management.

Contrary to the familiar saying, funds cheap get good, and expensive often pay off. I would even dare to argue that the fee charged can be inferred from the benchmark index’s performance over the next ten years!

In funds, as in the case of buying direct shares, it is advisable to keep the trading fee as a pain limit of one percent.

  1. Take a look at whether the funds are for growth or return.

In growth funds, dividends are reinvested in the fund untaxed, and taxes are paid on the income only when the fund units are sold. In a performance-based fund, the taxpayer clicks on a slice for each income-share payment.

In practice, without exception, I recommend growth funds. Long-term taxation of dividends has a significant effect on returns.

  1. Make sure that the funds selected do not overlap very much.

For example, if you decide to start investing in two ETFs – because two funds make a more diversified portfolio than one – take a look at what ETFs contain. For example, it doesn’t make much sense to buy both MSCI World and the S&P 500 ETF, as both of them play a major role in the U.S. and the emphasis quickly slips into the U.S. market. The name of the MSCI World Index is a bit confusing due to its history: World covers only 85 percent of the largest companies in developed markets, and more than 65 percent of these are U.S. companies. That is, emerging markets and small companies are left completely uncovered.

Of course, if for some reason you want to properly emphasize the Yankee market with a contract, duplication can sometimes be justified. If, on the other hand, you want to spread widely around the world, you should not choose the top 10 most popular ETFs in your portfolio. A large number of funds does not always correlate with broad diversification. Many ETFs can follow the same index, leaving the diversification benefit small.

Can I buy too many different ETFs in my portfolio?

Oh and no.

A very shredded and multi-line portfolio is more difficult to manage and outline. If you have three stockbrokers in your portfolio, all of which have multiple book-entry accounts and still have interlaced ETFs, and you want to know what weight you have even in the US, you may have a finger in your mouth.

Decentralization is often said to be an investor’s free lunch. However, it is often stated that too much diversification from stock picking does not lead to the desired return, but the return is inevitably close to the average return, in which case the investor “has to settle for the average return”. Well, since the index investor usually specifically wants the average return of the market, the index investor does not have these decentralization disadvantages in the same way. Thus, for an index investor, diversification is not in itself detrimental.

However, it must be remembered that if a fee is charged for trading, buying several small lots at a high cost will yield a return. If there is no charge for purchases or the charge is not fixed but, for example, a percentage, this problem will not arise. Some providers also offer monthly savings to which you can opt for a few ETFs for one smaller fee.

It is important to keep costs under control in both management fees and trading fees. When this is in order, you can find numerous ETFs in your portfolio without any major inconvenience.

Can an index fund portfolio be too centralized?

In my time, I started investing in Nordnet’s index funds and save on them regularly, mainly attracted to consumption. However, if you peek at the globe, you will notice that the diversification has eventually focused on a very small area, the Nordic countries (index funds Finland, Sweden, Denmark, Norway), even though I had diversified my money into many different funds.

Although there are always several companies in the funds, with certain exceptions, as required by law, the number of companies alone does not tell us all about the diversification of the fund.

For example, OMXH25, the 25 most traded shares on the Helsinki Stock Exchange, holds 25 shares as its name implies, but geographically, the companies on the Helsinki Stock Exchange are very close to each other. ETFs investing in a particular industry, on the other hand, may include dozens of companies from many countries, but there is no industry diversification. Sometimes, such a lack of decentralization is also appropriate.

That is, even if there are several funds in the portfolio, it is worth taking a look at whether the selected instruments cover a wide range of industries and regions, or whether you could choose someone else on the side of the selected fund or instead. I started refueling Nordnet’s book-entry account * in addition to super-funds in Western markets and emerging markets. This greatly improved my decentralization.

If only the Index Fund Finland can now be found in its portfolio, it is not the end of the world. The business operations of the companies on the Helsinki Stock Exchange are not limited to the borders of the country, but trade takes place all over the world, which means that a certain degree of geographical diversification arises through it.

What is the benefit of having many in a portfolio instead of one large ETF?

In short, the margin for maneuver.

For example, if you manage your investment with MSCI ACWI IMI – which covers almost all listed companies in all markets – you will not be able to take a look at your investment choices. For some, a really broad diversification in one fund is suitable, but I would still believe that a large part also has its views on the direction and trends of the world. These issues can be emphasized in investment activities by investing in a few different funds.

MSCI ACWI With IMI, the portfolio also includes what I think are unethical companies, dying industries, and markets you may not have heard of. So if you believe that companies classified as responsible, for example, will do better irresponsibly in the future, or if you do not want to be involved in companies that do not pass the screens, you should choose an SRI or ESG-screened ETF in your portfolio. Thus, for example, companies that are considered unethical are excluded from the fund.

An ESG or SRI in the name of the fund indicates that the companies have passed the sustainability assessment. The ESG screen is looser and eliminates obvious bad guys, i.e. the arms industry, for example, while SRI is tighter and emphasizes companies classified as responsible. Sustainability-screened ETFs are widely available in emerging and developed markets, Japan, Europe, and the US, among others.

If you choose a slightly unsexual, widely diversified ETF as the rock foot of the portfolio, you can flavor the portfolio as desired by purchasing other ETFs on top of the rock foot. Media-sexy options include e.g. industry ETFs, which today are numerous, ranging from digitalization ETFs to automation, robotics, the aging population (yes, very sexy), big data and clean energy, from climate change to healthcare and eSports, and from cannabis to artificial intelligence. You name it! Few sectors are those that the ETF would not be able to catch up with. Interest rates and commodities can also be easily invested through ETFs.

As you can see, index investing doesn’t have to be boring, although it is often branded as such in the debate.

Thus, a well-diversified equity portfolio can only be made with one ETF, a pair of ETFs investing in different markets, or by investing in a separate ETF for each continent, country or industry. Everything is equally right! With a larger number of ETFs, it may be easier to influence country- and industry-specific weights if you want to take a look, but a couple of large ones can already easily and cheaply access global markets.

If, on the other hand, you consider yourself a stock picker, but the domestic market seems to be the most natural field to play and there is no whining about stock picking, you can apply for diversification into the Finland portfolio through ETFs.

Thus, investing in an ETF is also suitable for the very side of traditional stock picking to balance the rumble or increase momentum. I have 70 percent of the portfolio of index funds and 30 percent of direct shares.

Fortunately, you don’t always have to choose a side, you can rarely snap the best delicacies of both camps!

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