I want to start investing my money. I've decided to invest a monthly fixed amount by buying ETFs. I am currently investigating different ETFs to decide on what my portfolio allocation will look like.
After a bit of research, I found out that a good place to start is to look at what Vanguard offers. So I did just that.
I noticed that Vanguard offers ETF that don't seem that differ much. For instance, how different can the 1) Vanguard Mega Cap (MGC), 2) Vanguard Mega Cap value (MGK) and 3) Vanguard Mega Cap Growth (MGV) really be?
To answer that questions, I ran the correlations on some of Vanguard's funds
So this seems to answer my question. The funds mentioned above have a correlation > 99.7%.
We also see that the correlations is extremely high on a number of these funds. For instance between the Vanguard S&P 500 (VOO) and the Vanguard Total Stock Market (VTI) we have 99.97% and between the Vanguard S&P 500 (VOO) and the Vanguard Extended Market (VXF) we have 99.2%.
With numbers like these, combining these ETF's in a portfolio makes no sense since they all move exactly the same way. I should therefore just pick one by looking at the traded volume and the management fees.
For the sake of the ETF, let's pick the Vanguard Total Stock Market (VTI).
In the correlation matrix, I see that 2 funds stand out by having a lower correlation with the VTI. These are the Vanguard FTSE Emerging Markets (VWO) and Vanguard FTSE Europe ETF (VGK). There have - respectively - a correlation - compared to VTI - of 69% and 85%. Also, their own correlation is of 79%.
So here we have it. On one hand a non-diversified portfolio composed only of 1 ETF, the VTI. And on the other a diversified portfolio composed of 3 ETF's: the VTI, the VWO and the VGK. Let's assume an allocation of 50%, 25% and 25%. In the following example, I will also assume perfect monthly re-balancing.
Let's have a look at the results.
We can see that both portfolios show pretty much the same story. Naturally, I've also computed the correlation between both portfolios. The result is 98%. With such a high correlation, it's no surprise that the diversified portfolio slightly under-performs: the management fees twice as high!
Portfolio VTI: 100% * 0.04% = 0.04%
Portfolio "Diversified": 50% * 0.04% + 25% * 0.14% + 25% *0.10% = 0.08%
From this little experiment it seems like the only sensible move is to put all my money on the cheapest Total Stock ETF I can find (basically any of the "S&P 500", "Extended Market", "Total Stock", "Mega Cap", etc. funds).
What do you think on this? Am I missing part of the picture? Does diversification hold benefits I haven't considered? Am I looking at diversification in the wrong places (maybe I should consider industry rather than geography)?
Any insights on this is more than welcome! :-)
Update: I have added 2 more funds to the correlation matrix: a small-cap ETF (VB) and a mid-cap ETF (VO). Updated Correlation Matrix