“The beginning of wisdom is to call things by their proper name.” – Confucius
Diversification is often touted as the backbone to any disciplined portfolio. We tend to view the basic principle as important but often inaccurately applied to portfolio management, as the point of diversification is to help you offset risk of loss. Diversification often does not enhance returns on the upside – its basic definition prevents that by owning uncorrelated assets. But, similar to a seat belt or airbag, one does not truly appreciate it until you need it.
True diversification, however, has gotten harder as the world has become more correlated. Often stocks, bonds, and even commodities all move the same direction now – making it challenging to find something truly uncorrelated and a risk reduction asset. Investors need to be strenuously looking under the hood at their ETFs and mutual funds to understand their real risks. Below is a table of 5 popular ETFs representing 5 very different indexes: core, tech, growth, value, and emerging markets. But the overlap between the 4 US large cap funds is massive. And, if you are depending on emerging markets to bail you out, realize over 44% of EEM is leveraged to the AI trade with semiconductors and memory. Owning these 5 ETFs would possibly make you feel diversified, when in fact AI and tech remain the main drivers of all 5 of them.
The Russell 1000 Value Index is 15% exposed to the Magnificent 7 and also includes INTC and CSCO- not your grandpa’s value index by any means. You want your value stocks to be true value stocks, not just growth in disguise. It really is a period of caveat emptor, especially as the AI trade rips higher. This may mean looking at funds that are NOT in the top quintile for 1-, 3-or 5-year returns, since those are highly leveraged to AI. But it is time to take a hard look at what you own, understand how correlated some of the investments might be, and ask yourself – are you diversified if AI takes a dive? Being prepared and making adjustments now when markets keep hitting records could help prevent a panic if the markets take a turn. Concentration might amplify returns in a bull market, but diversification protects from the wipeout.