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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

Correlation Matrix on Vanguard ETF's :

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.

VTI ETF versus Diversified Portfolio

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

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  • None of those look like commodities ETFs/ETNs, maybe find one of those to compare against. Also, to clarify, you're only wondering about whether within an ETF portfolio you can diversify (further than the diversification inherent in an ETF)? You're already planning to diversify investments outside of your ETF purchases, right?
    – Hart CO
    May 3, 2018 at 14:56
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    I bought into VTI, a small-cap, a mid-cap, and a foreign developed. Boom. Diversity.
    – WakeDemons3
    May 3, 2018 at 16:22
  • @HartCO: 1) I can look into commidities ETF. This is the sort of thing I was thinking about when I wrote "Am I looking at diversification in the wrong places". I can look into commodities and I can play with currencies. Any other ideas? 2) No, I am not planning in having other investment outside of my ETF portfolio. Do you think I should already think about this? I figured I had a few years ahead of me ...
    – VictorOnline
    May 3, 2018 at 17:01
  • You can't invest a fixed dollar amount in an ETF unless the ETF (or your brokerage) allows you to buy fractional shares: shares are generally sold in integer numbers and preferably in multiples of 100 (round lots) to minimize brokerage fees.
    – Dilip Sarwate
    May 3, 2018 at 17:09
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    I don't see your point. You can't diversify by cherry-picking funds that are almost the same by design? Obviously. A fund that by definition covers the entire stock market overlaps with other stock funds? Obviously. Vanguard does have other ETFs that have much less overlap. VTI (total stock market) + VT (total world stock) covers almost all the stock in the world; add in BND (total US bond market) and BNDX (total int'l bond) and you have basically every stock and bond in the world. How is that not diversified?
    – Kevin
    May 3, 2018 at 18:58

1 Answer 1

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As these Vanguard index ETF hold many stocks, this might be clearer if you consider the underlying portfolio of stocks that you end up with when buying these funds. For instance, in your first example Vanguard Mega Cap is an ETF of all mega cap stocks including almost all of the stocks in Vanguard Mega Cap Value and Vanguard Mega Cap Growth (check the holdings for each). You can (essentially) make MGC by combining MGK and MGV. So, adding these two funds does not diversify a portfolio with just MGC.

However, VTI (US stocks) holds an entirely different set of stocks than VGK (Europe) and VWO (Emerging). So holding all three is diversifying in this case. To understand diversification, it's better to check correlation amongst the funds as you are interested in to see how they relate to each other. Now, the correlations amongst these three funds may be rather high all around ~0.75 (daily, 5/3/2018, last two years, Bloomberg), but that is still a good amount of diversification. I think it is great you are checking fees closely not enough people do that, but a tiny extra fee of 0.04% is likely worth that extra diversification.

If you look at the holdings some more you will notice that funds like VTI are already broadly diversified across industries (see the "Equity sector diversification" section. It is also diversified across company size. You can check and see that the stocks in MGC are in VTI but VTI holds smaller stocks as well. Besides geography and size, other common diversification directions (with even lower correlations to equity) are bonds (BND), real estate (VNQ) and commodities (though I find commodities tough to recommend).

Addition to clarify:

We can see that both portfolios show pretty much the same story

Actually those two portfolios (100% VTI and Diversified) are very different over the time period you explore. The correlation being high only means they tend to change in the same "direction" (gains/losses) day-after-day but the magnitude and drift of the changes matters a lot as well, especially over time. The graph you have there shows the diversified portfolio beating the other portfolio significantly during some periods and losing in others.

Correlation is just one useful tool among many toward building a diversified portfolio.

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  • Thanks a lot for your answer! I added 2 new funds in my correlation matrix. You can see that the small-cap and mid-cap are correlated at 99.82% and both are > 99.5% correlated to VTI. So it seems that they don't in fact offer any additional diversification. This is why I am not focusing on the underlying components on the ETF so much. Although these ETF's may hold different stocks, if they are perfectly correlated, why bother? The only thing I see here is that VTI, VO and VB perform in the same way except VTI had smaller management fees (I agree however that 0.01% wouldn't kill me :-) )
    – VictorOnline
    May 3, 2018 at 17:24
  • Regarding bond and commodity ETFs, this is the first item on my to-do-list. I'm still focusing on the stock portion of the portfolio but I really need to consider these as well. To be honest I even forgot about real estate so thanks a lot for that!
    – VictorOnline
    May 3, 2018 at 17:31
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    It is very important to understand the underlying components so that you can understand why funds are correlated and why they may or may not diversify. For instance, VTI includes most of the stocks in the mid-cap and small-cap funds and that is why adding those funds does not diversify a 100% VTI portfolio instead it would tilt your portfolio toward smaller stocks.
    – rhaskett
    May 3, 2018 at 17:53
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    Two funds may be highly correlated during certain periods and less correlated during others. Understanding what you are buying will help you understand if those correlations will be persistent over time. For instance, VTI and VWO go through periods where they are more or less correlated, but because you are buying an entirely different set of stocks with VWO you can have more faith that owning both will have a diversification effect.
    – rhaskett
    May 3, 2018 at 18:01
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    Check out the wiki page en.wikipedia.org/wiki/Correlation_and_dependence. It's worth a full read here, but for a quick view look at those graphs on the side. There are a number of lines with correlation 1 but they all have different slopes. Correlation is a measure of how close to "linear" a relationship between two variables is but not the magnitude (slope) of that relationship.
    – rhaskett
    May 3, 2018 at 21:01

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