Do more ETFs mean more diversification?

Two funds, four companies

Suppose the fund shares you own are worth $600 in Fund 1 and $400 in Fund 2 today. These are current values, rather than what you paid. The funds and companies are fictional, and both complete holdings lists use the same valuation time.

Each percentage below is the company's share of the value inside that fund. We use net asset value, or NAV, based on what the fund owns minus what it owes. Assume the ETF's traded price equals NAV. Both funds own stocks directly, with no cash, borrowed money, or derivatives—contracts linked to other investments. There is no magnified investment exposure, known as leverage. We also exclude fees and currency effects.

Scroll wide tables sideways. Keyboard: focus the table, then use the arrow keys.

Fund 1 holds four companies and Fund 2 holds three, but A, B and D appear in both. There are four different companies altogether. Fund 2 changes how much money you have connected to each existing company rather than adding new names.

You own shares of the funds, rather than directly owning the company shares inside them. The calculation below traces how much of your money depends on each company through those funds. That is your economic exposure.

Company A accounts for $440 of your $1,000

Start with money rather than adding the percentages. A makes up 40% of your $600 in Fund 1, so $240 depends on A. Fund 2 adds 50% of $400, or $200. Together, $440 of the $1,000 account is connected to A. Its combined weight—the proportion of the account—is 44%.

The 40% and 50% in the first table refer to different-sized fund holdings. Adding them to get 90% would act as though each fund contained all your money. Averaging them to get 45% would work only if you held equal amounts in the funds.

Your money is split 60/40, so the formula is 0.6 × 0.4 + 0.4 × 0.5 = 0.44. The first number in each pair is that fund's share of your account; the second is A's share inside it. This is the same calculation as adding $240 and $200, then dividing by $1,000.

Fund 2 adds no new company, yet it changes the mix. A's weight rises from Fund 1's 40% to the combined 44%; D's rises from 10% to 18%. How you divide money among funds, your allocation, matters as well as which funds you choose.

One falling stock affects both funds

Let A's share price fall 20%, while B, C and D stay unchanged. Keep the same assumptions, with no trading, rebalancing, expenses, tax, cash paid out by the funds or currency changes during this move. Rebalancing means buying or selling to restore a chosen split; here we leave all share counts alone.

Fund 1's $240 connected to A loses $48. Fund 2's $200 loses $40. Your account loses $88, or 8.8% of its original $1,000. The fund holdings are now worth $552 and $360, making $912 together. Two fund names did not turn A into two independent companies.

What remains connected to A is $440 − $88 = $352. Its new share of the account is $352 ÷ $912, approximately 38.60%. The weights changed without a trade. An old calculation need not describe today's account. Our portfolio rebalancing example shows how trading existing holdings or adding cash changes those weights again.

Different names can still share risks

Different companies can be affected by the same event. A shortage raising costs throughout an industry can hurt several businesses at once. Counting names would miss that shared risk.

Our four companies are all stocks. Bonds are a different kind of investment: money lent to a government or company in exchange for promised payments. Such broad kinds of investment are called asset classes. Adding more stock ETFs spreads money within stocks; adding another asset class changes the mix in another way. Neither guarantees protection from losses or a broad market decline.

Overlap can also be deliberate. You might add a fund focused on one industry, or sector, to a broad-market fund because you want more of that industry. The repeated names may be an expected part of that choice. The combined weights show how much you added.

This example sets no ideal number of funds, safe company weight or requirement for zero overlap. It describes where the money is invested. You can then compare that result with the mix you intended.

Start with the full holdings list and its date

A list of the ten largest holdings can show a major overlap, but it cannot show whether the rest overlap too. Look for a full list where available, and check its date. Pairing an old list with today's account values gives an estimate of today's mix.

Use current fund values expressed in one currency. Then match identifiers as well as names. Two listings can refer to one company, while a company's shares and its bonds remain different investments. A country label also need not describe where its companies earn revenue or every currency affecting them.

If you directly own shares in the same company, add their current value to that company's amount and to the account total. Adding only to the company amount while dividing by the smaller ETF-only total would overstate its percentage.

With actual funds, market prices may differ from NAV. Some funds also use contracts to produce their returns and hold other assets as security for those contracts, called collateral. A list of collateral alone does not tell you which market movements determine the contract's return. The simple stock multiplication above may not describe that arrangement.

Keep each fund's current value and holdings date beside the largest combined company weights and your reason for holding it. You can compare those entries with your next statement. Counting ETF names alone would leave the $440 linked to A hidden.

About the examples

The funds, companies, tables and calculations are fictional. Holdings use the same valuation time and currency, with direct stock ownership, no cash, debt or derivatives, and market prices equal to NAV. The loss example excludes trading, rebalancing, expenses, tax, distributions and currency changes. No target allocation is recommended. Editorial policy.