Most investors understand the concept of diversification. Spread your money across different asset classes, sectors, regions and investment managers, and your portfolio should be better equipped to withstand market shocks.
Yet despite unprecedented access to ETFs, managed funds, private assets and global markets, many portfolios may be less diversified today than investors realise.
The issue is diversification is not about the number of funds or ETFs you own. It’s about the number of genuinely different return drivers you’re exposed to.
An investor may hold four global ETFs and two US managed funds. On paper, that looks highly diversified. In practice, many of those funds may be heavily invested in the same few technology stocks. Moreover, they may be exposed to the same drivers: equity market sentiment, global economic growth, falling interest rates, and relatively high valuations.
This is worthy of attention right now. The market environment that rewarded investors over the past decade may not be the environment that defines the next decade.
A useful way to think about diversification is through correlation.
Correlation measures how closely two investments move together. The closer the correlation is to 1, the more similarly those assets tend to behave. The closer it is to zero, the more independent they are.
Many investors assume that holding multiple asset classes automatically gives them the benefits of diversification.
The data tells a different story.
J.P. Morgan's research shows that over the decade to March 2024, the correlation between US equities and most mainstream asset classes was closer to 1 than most portfolio theories assume:
Asset Class
| Correlation to US Equities
|
Developed International Equities |
0.90 |
Emerging Market Equities | 0.80 |
Private Equity | 0.81 |
Listed REITs | 0.78 |
Hedge Funds | 0.82 |
Gold | 0.23 |
Source: J.P. Morgan Asset Management, Guide to the Markets
These figures challenge the common assumption that each of these mainstream asset classes, apart from gold, provide exposure to unique drivers.
They clearly don’t.
The upshot is that investors who believe they’re diversified across multiple asset classes may actually be holding investments that are driven by the same underlying market forces, particularly global equity sentiment.
Why does this matter?
In short, the diversification benefits of apparently diversified portfolios are likely to prove much weaker than expected when markets next come under pressure.
It’s worthwhile considering this issue now, before it’s too late to take corrective action.
Diversification is not only about how many ETFs or funds an investor owns.
It is also about what those ETFs and funds actually hold.
Here’s the thing. An Australian investor may own a global ETF, an international managed fund, a diversified super option and a technology-themed allocation, all of which provide exposure to the same small group of mega-cap US companies.
The numbers are striking.
The ten largest constituents of the S&P 500 account for a hefty 39% of the index, while the largest single constituent, Nvidia, represents 7.6%.
For an index often used as shorthand for the US market, that means almost two-fifths of this portfolio is represented by just ten companies.
Source: S&P Dow Jones Indices
This is a significant drift away from the diversified global economy of the past.
The momentum behind these big tech stocks in the US has been unstoppable of late.
The US technology sector has rallied 42% over the last two months, the largest two-month gain in 24 years. This also marks the second-strongest rally this century, surpassing even the 40% gain seen during the 2000 Dot-Com Bubble.
Meanwhile, the S&P 500 is up 20% since its March 30th low, with the top 10 stocks contributing around two-thirds of the index's gains. Half of the top ten contributors were semiconductor stocks, with the AI trade hotter than ever.
Beyond the obvious risks posed by over-concentration, there’s also a growing disconnect between valuations and earnings growth amongst the top ten largest US stocks. Whilst they represent, 39% of the index, they contribute around 30% of the S&P 500’s earnings.
This is evidence of valuation expansion amongst the largest stocks.
Global equity benchmarks have also reshaped by the same leadership concentration.
The US share of the MSCI All Country World Index has risen from 52% to 64% over the past decade.
Hence, the question to ask is: How much of my portfolio ultimately depends on the same handful of US technology and AI-related companies continuing to outperform?
For investors using market-cap-weighted global ETFs, this is especially relevant.
Market-cap weighting automatically allocates more capital to companies that have already become larger. That can be powerful during momentum-led bull markets, but it can also increase concentration risk when leadership narrows.
The next layer of due diligence is to look through the fund labels and ask what is really driving returns: broad economic growth, interest rates, AI capital expenditure, US mega-cap earnings, or genuinely different sources of return.
Search and compare a purposely broad range of investments and connect directly with product issuers.
If the first step towards better diversification is understanding what drives your portfolio, the second is identifying sources of return that do not depend on the same economic outcome.
This doesn’t mean completely abandoning equities.
Shares remain one of the most powerful long-term wealth creation tools available to investors.
Rather, it means recognising that a portfolio dominated by global equities, growth-oriented ETFs, and property may ultimately be making a relatively concentrated bet on equity sentiment, continued economic growth, and healthy corporate earnings growth.
The challenge for investors is therefore is finding different and unique return drivers.
Here are some potential ideas:
The key lesson is that genuine diversification comes from combining assets whose outcomes depend on different economic conditions.
Equities depend heavily on earnings growth.
Private credit depends largely on loan performance and income generation.
Gold often responds to inflation and monetary uncertainty.
Short-duration bonds derive much of their return from income and capital preservation.
The more independent those return drivers are from one another, the greater the potential diversification benefit.
That’s ultimately the challenge posed by modern portfolio construction.
The relevant question should evolve from ‘How many investments do I own?’ to ‘How many genuinely different ways can my portfolio succeed?’
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Consistent returns aiming for cash + 1.50%
An efficient income solution provided through a diversified exposure to predominantly AUD denominated investment grade Australian and global floating and fixed rate bonds.
GDX gives investors exposure to a diversified portfolio of companies involved in the gold mining industry. GDX aims to provide investment returns, before fees and other costs, which track the performance of the Index.
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