Exchange traded fund (ETF) diversification can refer either to the way that these financial instruments are structured to protect investors, or to a recommended investment policy where several different types of ETF funds are purchased to spread an investor's risk around to multiple sectors of the economy. Since exchange traded funds by their nature try to cover broad sectors of the market, it can be confusing when financial advisers talk about ETF diversification because the principle is already built into all ETF funds to some degree. Not all ETF funds track wide sectors of an economy, however, so it is important for investors to know exactly what they are buying into so that they can minimize risk and maximize their potential for gains.
Financial diversification usually represents a standard where a range of 20 different types of investments make up a portfolio from different industries and with different levels of risk. This does not translate to an equivalent portfolio of 20 different ETF funds, however, as they are already individual composites of many different types of stocks. Very large ETF funds such as some traded on the US American Stock Exchange (AMEX) and New York Stock Exchange (NYSE) are indexes of stocks for anywhere from 90% to almost 100% of the entire US stock market. These types of funds often have words like “total stock market” in their names or are named after key stock tracking services such as the Standard and Poor's (S&P) indices in the US, with similar indices also existing in countries like Australia, Canada, and India.
Other types of ETFs track the bond market, government treasury instruments, or satellite markets that only make up a small percentage of a larger group of industries such as the real estate market, small cap investment companies, and foreign stocks. Fund diversification, therefore, requires that an investor place a large portion of their assets into exchange traded funds that track the broader marketplace, and then also invest in many smaller ETF instruments to make the portfolio more resistant to overall losses. A common mistake in ETF diversification is to buy a variety of ETF funds that overlap into similar areas of the marketplace, which provides a false sense of security and is prone to losses when the general economy faces a downturn. This is referred to by brokers by the slang term "diworsification," and it is avoided by a general recommendation that 80% of investment capital go into ETFs that cover nearly the entire economy, and 20% of the capital is invested into narrower types of ETFs like those that focus on small cap companies.
The investor needs to also look at ETF diversification in terms of for what the growth is intended to be used. If it is a type of retirement diversification, for instance, then ETFs that focus on less risky areas of an economy such as utilities and bonds should be the focus. If the ETF diversification is focused on rapid growth and a willingness to take greater risks, then ETF funds focused on small cap companies that are growing rapidly, commodities markets that change on a seasonal basis, and reliable foreign funds should be considered.
Asset diversification overall should include investment outside of the ETF market to some degree, such as in real estate or direct investment in large cap companies known as blue chip stocks, which are slow growing but also the most reliable and stable of publicly-traded companies. ETF diversification in general, however, is seen as a very convenient way to get broad exposure to the market for an average investor with limited capital, and it is a form of investment diversification that requires minimum maintenance with low fees. ETF portfolios are one of the most trusted methods of generating financial growth and income if the mixture of exchange traded funds that is purchased are carefully analyzed beforehand by investors so that they know exactly what each fund represents.
