Many advisors may be surprised to learn how many securities are needed for effective portfolio diversification.
A common misconception among advisors is that true diversification and risk reduction can only be achieved by holding a large number of individual securities.
However, studies have shown that portfolio risk, defined by the standard deviation of returns, can be reduced significantly by holding only about 20 securities, according to Nick Elward, Natixis Investment Managers senior vice president and head of institutional product and ETFs.
In fact, any additional portfolio constituents beyond 20 will not materially reduce overall risk. However, the 20 securities selected must exhibit diverse factors, according to Elward. Additionally, the securities should not be overly correlated to one another.
Experienced active managers are uniquely positioned to evaluate these opportunities and construct portfolios optimized for mitigating portfolio risk. The investment team behind an actively managed fund can deliberately lean into concentration. Furthermore, they can capture compelling investment opportunities while navigating risk.
According to Elward, active, bottom-up portfolio strategies can enhance diversification benefits by moving toward more concentrated portfolios of high-conviction, deeply researched ideas.
The Natixis Loomis Sayles Focused Growth ETF (LSGR) and the Natixis Vaughan Nelson Select ETF (VNSE) are examples of ETFs managed by experienced active managers. LSGR and VNSE hold 22 and 30 securities, respectively.
Broad Indexes Don’t Necessarily Provide True Diversification
As it stands, many portfolios may not be as well diversified as investors think. Many investors allocate to ETFs tracking broad indexes to diversify their portfolios. However, traditional cap-weighted indexes are designed to continue to allocate to past winners, making them inherently backward-looking and often highly concentrated. Being overly concentrated at the company level introduces significant idiosyncratic company risk to a portfolio.
Additionally, these broad indexes have reached record concentration levels in recent history. History has shown that markets tend to normalize after periods of high concentration. Cap-weighted indexes have historically lagged after these peaks in concentration.
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