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As the economy continues to shrug off bad news, allowing stocks to move higher, broad equity exposure could be ideal for many investors. This could be especially true for investors who are still light in stocks and are hanging on to low yielding bonds and other relatively safe securities for their holdings at this time. Yet for those that are still on the fence, ETFs that have impressive levels of diversification could be the way to go. These securities look to offer solid exposure to equity markets but at the same time, almost entirely eliminate company specific risk.
This can be done by looking at funds that both hold a great deal of holdings as well as those that do not allocate a big chunk of assets to any one security in particular. After all, the diversification of a fund that holds 1,000 securities but puts 20% in its top holding is likely to be less than a similar product that also follows one thousand companies but weights them all evenly (read Alternative Weighting Methodologies 101).
If investors are looking for a more mathematical approach, XTF.com looks to define this process with what it calls ‘concentration risk’. In this process, the firm uses the average constituent weight and then adds the square root of the variance of constituent weights adjusted for the total number of constituent securities. The firm then goes on to say ‘the lower the weight of each constituent security, and the more securities, the better.’ As an example, SPY has a concentration risk of about 8%, while sector and smaller country specific products such as Mexico’s EWW and the iShares Dow Jones US Energy Fund (IYE) tend to have much higher concentration risks, coming in at 28.1% and 31.4%, respectively.
For investors looking to hone in on securities that have the lowest rating on these measures, which arguably have the least company specific risk, we have highlighted three funds below which are both extremely spread out and possess a great deal of holdings as well. These funds could be ideal for those worried about a downturn in some companies but at the same time, are looking to slowly cycle back into the market given the mildly improving fundamentals of the economy (concentration risk data is courtesy of XTF.com):
First Trust Value Line Dividend Index Fund (FVD)
For investors seeking impressive diversification in the dividend space, FVD could be an interesting choice. The fund has a concentration risk of just 1.2% and holds 167 securities in total, putting just 6.1% of assets in the top ten holdings. This is especially impressive given the fund’s relatively active methodology and expense ratio of 70 basis points. The product only invests in firms that have a “Safety” Ranking of 1 or 2 from Value Line and that also have a dividend yield higher than the S&P 500 average. Given this focus, but admittedly thanks to in part to the equal weight methodology that it uses, FVD manages to have a solid concentration risk level, as well as a decent dividend of about 2.5% (see Inside The SuperDividend ETF).
Rydex MSCI EAFE Equal Weight ETF (EWEF)
If investors are looking for an international focus in a widely dispersed fund, EWEF could be the way to go. EWEF has over 800 securities in its basket and has a low concentration risk of just 0.7%, suggesting it could be the pick for investors who want to gain exposure to Europe and developed Asia but are worried about some of the risks that could impact individual securities there. Top sectors include industrials (20%), financials (16%), and consumer cyclical (14%), suggesting a nice mix between sensitive and defensive sectors. From a country perspective, Japan takes the top spot at about 30% of assets while the UK and France round out the top three (also read Three European ETFs Beyond The Euro Zone).
Rydex S&P Equal Weight ETF (RSP)
With a concentration risk level of just .4%, RSP takes the top spot in terms of lowest concentration risk. The product holds all 500 stocks of the S&P 500 index but instead of weighting them by market cap, uses an equal weighting methodology to accomplish its task. This produces a fund that is more heavily tilted towards mid and small caps than products such as SPY and other market cap weighted funds. Furthermore, it heavily reduces the percentage of holdings in the top ten as SPY has about 20% of its assets in its top ten while RSP has just 2.7% in comparison. Thanks to this difference, RSP provides exposure to the same 500 important stocks, but does so in a way that offers investors unparalleled diversification (see Three Construction ETFs For An Economic Recovery).
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Author is long RSP.