Diversification is important to manage the risk of your portfolio. It also allows you to gain exposure to different assets. Exchange-traded funds (ETFs) are securities that allow you to spread your money across different assets. In this blog, we explore if ETFs are good for diversification.
What is Diversification?
Diversification in investing is holding various assets so that the risk from any single asset is reduced. Investing in any asset exposes you to a certain amount of risk. But, all assets may not have the same risk-to-return ratios in all scenarios. Also, they might underperform in different periods. So, through an effective diversification strategy, you can reduce the amount of risk in your portfolio.
Diversification is important in investing because it allows you to build a portfolio with the expected risks and returns that suit you better. In a well-diversified portfolio, you will have exposure to various assets from different asset classes.
You can fix the diversification ratio between safer assets like government bonds and riskier equity stocks according to your risk profile.
What is an ETF?
Exchange-traded funds (ETFs) are securities traded on the exchanges. They have the characteristics of both stocks and mutual funds. They can be traded over the exchange, just like a stock during market hours. At the same time, ETFs give you exposure to various assets like stocks, bonds, gold, etc.
ETF investments in India can be made on BSE as well NSE.
How can ETFs help diversify a portfolio?
In India, various ETFs follow indexes like Nifty 50, SENSEX, Nifty Smallcap, etc. You can use a combination of these ETFs to build a complete ETF portfolio or a portfolio of ETFs and other assets. A well-diversified ETF portfolio could be made using just index ETFs of a domestic index like Nifty, world index like NASDAQ, and safe-haven assets. Read this blog if you want to know how to diversify an ETF portfolio.
Alternatively, you could build a good ETF portfolio with sectoral ETFs and individual stocks. Suppose you identify that a certain industry will grow in the next 5 years. You might be able to construct a portfolio with an ETF that tracks the index of that industry and stocks from that sector that are expected to perform well. This way, a portion of your portfolio will earn returns close to industry returns while the other portion is focused on growth stocks.
The above strategy allows you to find a midway between risky direct investments and index returns. Compared to just direct investment, having a balanced portfolio with ETFs allows you to reduce the risk you are taking.
In India, with multi-asset allocation ETFs, portfolios with exposure to various asset classes can be built using just one ETF. You may modify this portfolio by adding assets of your choice.
Conclusion
Exchange-traded funds (ETFs) can be used by investors to build well-diversified portfolios of just ETFs or ETFs in combination with other assets. Nowadays, you can even invest in multi-asset allocation ETFs that give you exposure to various asset classes. ETFs are useful for diversification as they spread your money across various assets at lower entry points.
At WealthDesk, you will find ETF and stock portfolios made by SEBI-registered professionals. These portfolios, called WealthBaskets, follow a certain theme and investment strategy. All assets in a WealthBasket are transferred to the subscriber’s Demat account.
FAQs
It depends on what you are comparing them with. ETFs are generally more diversified than direct investments in stocks. You might have to check the allocation charts to compare diversification levels among different funds.
A multi-asset ETF would be best for diversification as you would spread your funds across various assets in various asset classes like stocks and bonds.
You can create a diversified portfolio with ETFs that has exposure to various asset classes by using multi-asset allocation ETFs or a combination of index ETFs that follow domestic, global and safe haven indexes.
You can choose to invest in ETFs that pay dividends. There are ETFs that pay dividends on both NSE and BSE.
