A diversified portfolio is a coat of many colours

Dolly Parton’s memorable song Coat of Many Colors recounts how her mother sewed a coat from a box of rags someone had given her. The individual pieces mattered, but so did how the pieces fit together.

There’s something in that for investors. We spend plenty of time choosing individual investments, but perhaps less thinking about how they fit together. In our view, diversification deserves more thought than just assembling a list of holdings.

The first lesson every investor learns

Most investors are familiar with the concept of diversification thanks to it being explained ad nauseam in just about every beginner’s investing course. We know that if we put all our eggs in one basket, we leave our returns dependent on how that investment performs. But if we spread our investments across several different assets, the volatility of returns is likely to be reduced.

Portfolio diversification has existed since the early 1950s when Nobel Prize laureate Harry Markowitz argued that a near 60/40 split between shares (growth assets) and bonds (defensive assets) was considered the optimal portfolio. This combination is still used by many institutional investors as a benchmark today.

In the 1980s, David Swensen, the former chief investment officer of Yale University’s endowment, added private equity and real assets to the optimal portfolio, in the hope that returns could be sourced from more options. Swensen went on to deliver a 13% p.a. annualised return for over 35 years.

Australia’s Future Fund employs a similar approach today, investing across private and public asset classes.

The rise of the diversified ETF

Investors today can access all these principles through diversified ETFs. Sometimes called “all-in-one” products, these funds can give investors access to many asset classes and exposures in one trade for a modest fee.

These products also exist for any investor because they can be customised to meet their risk. Investors can choose from diversified ETFs with different risk profiles, from conservative options to those invested entirely in growth assets.

But the labels don’t always match what investors expect. A fund labelled “Balanced” might hold 50% growth assets and 50% defensive assets, while the VanEck Core+ Diversified Balanced Active ETF (VBAL) has a 60% growth/40% defensive allocation. An even bigger discrepancy exists when an investor compares “growth” ETFs.

To solve for this, we think investors should consider three things:

1. How the investments are selected
2. The mix of assets
3. The breadth of assets

How the investments are selected

Many diversified ETFs provide exposure to the share market through market capitalisation ETFs, meaning the biggest companies receive the largest allocations. In an S&P/ASX 200 allocation, that means nearly half the money invested in Australian shares goes to just 10 companies.

Doing this means you gain exposure to many businesses all at once. But it also means your returns will largely depend on the fortunes of the largest banks, miners and consumer names. That concentration can leave a large share of the portfolio exposed to the same economic pressures.

In contrast, VanEck’s Core+ portfolios access Australian shares through an equal weight approach. Each company starts with the same weight at the scheduled rebalance, giving businesses in other sectors such as healthcare and industrials a greater opportunity to contribute to returns.

A mix of assets with different characteristics

Some diversified ETFs concentrate on shares and broad bond funds while a select few may add a dedicated infrastructure allocation. While this is simple, it’s not necessarily the most effective. And, as the 2022 experience showed, owning shares across several countries does not remove the risk of those markets falling together.

The VanEck Core+ series goes further, with dedicated allocations to international property, infrastructure, gold bullion and gold mining shares. In the balanced and growth ETFs of the series, both developed and emerging market fixed income is included as is an allocation to cash-plus securities.

These exposures give the portfolios more sources of return, so their performance need not depend on any one asset class.

Breadth within each market

No asset class is a monolith. That’s why investing has many factors, styles and strategies to help investors outperform depending on the state of the markets.

For instance, quality strategies assess companies’ profitability, debt and earnings consistency. Value strategies look for companies trading at attractive valuations, using measures such as forecast earnings and cash flow to help distinguish a bargain from a value trap. And a growth-at-a-reasonable price (GARP) approach to investing in smaller companies helps investors find opportunities and screen out potential duds.

Core+ combines quality and value strategies in international shares, alongside a dedicated allocation to international small companies selected for their quality characteristics. Its emerging market equity exposure selects companies using multiple investment factors.

This is not to suggest that other diversified portfolios overlook these asset classes. But in our view, how those opportunities are selected and combined can make a substantial difference to an investor’s returns.

True diversification

We believe true diversification must be built from the ground up, with each allocation chosen for what it contributes to the portfolio, including when markets become unsettled.

The VanEck Core+ Diversified Active ETF series, consisting of VanEck Core+ Diversified Balanced Active ETF (VBAL), the VanEck Core+ Diversified Growth Active ETF (VGRO) and the VanEck Core+ Diversified High Growth Active ETF (VHGR), is built on the principles set up by Markowitz, Swensen and the Future Fund. Each ETF is designed to target outcomes rather than allowing market capitalisation to decide the unintended exposures.

The portfolios spread risk across shares, listed property, infrastructure and gold, with fixed income and cash-like investments included in VBAL and VGRO. You can learn what’s inside each individual Core+ ETF by going to the Holdings & Allocations section of each ETF’s website.

Your money has a world of possibilities, so we think your portfolio should reflect that. As Dolly’s mother showed, there’s value in knowing how to bring different pieces together. A diversified portfolio deserves the same care.

Key risks

An investment in the ETF carries risks associated with financial markets generally, asset allocation risks, underlying fund risks, investment management risks, ASX trading time differences, industry sectors, foreign currency, country or sector concentration, political, regulatory and tax risks, and fund operations. See the PDS and TMD for more details.

VBAL is likely to be appropriate for a consumer who is seeking capital growth and a regular income distribution, is intending to use the product as a standalone solution or major, core, minor or satellite allocation within a portfolio, has an investment timeframe of at least 3 years, and has a medium risk/return profile.

VGRO is likely to be appropriate for a consumer who is seeking capital growth and a regular income distribution, is intending to use the product as a standalone solution or major, core, minor or satellite allocation within a portfolio, has an investment timeframe of at least 5 years, and has a high risk/return profile.

VHGR is likely to be appropriate for a consumer who is seeking capital growth and a regular income distribution, is intending to use the product as a standalone solution or major, core, minor or satellite allocation within a portfolio, has an investment timeframe of at least 5 years, and has a high to very high risk/return profile.