The concept of diversification is not well understood by investors, I think, so I hope this will spur some thoughtful discussion.

Basically, diversification is the process of spreading the total amount risk in a portfolio more evenly across the sources of risk. A well-diversified portfolio allocates its risk across many independent sources as feasible.

Some investors confuse "diversification" (which is basically the

*balancing*of risk) with "de-risking" (which is basically the

*reducing*of risk). Improvements in diversification can increase, decrease, or leave unchanged the overall

*level*of risk in a portfolio. Likewise diversification can increase, decrease, or leave unchanged the overall

*level*of expected return in a portfolio. In this way, you can imagine a portfolio being supported by three legs or pillars: expected return, expected risk, and level of diversification. For any given level of expected return and risk, the investor should prefer a higher level of diversification to a lower level.

Mathematically, diversification effectively depends on the correlations of portfolio holdings and the variance (or volatility) of those holdings. Generally speaking, low correlations and higher variances make an asset a better diversifier. One way to easily estimate the level of portfolio diversification to compute the average volatility of the portfolio assets and compare that to the overall volatility of the combined portfolio. The higher the ratio, the more diversified the portfolio.

In short, the higher the diversification ratio the more diversified the portfolio. There are a lot of technical qualifications, but that's the gist of it.

What follows is a list of Vanguard ETFs (I only computed funds with inception dates in 2015 or earlier) with the diversification ratio computed in a 50/50 portfolio with Vanguard Total Stock Market ETF (VTI).

Code: Select all

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Vanguard Extended Duration Trs ETF (EDV): 1.60
Vanguard Long-Term Treasury ETF (VGLT): 1.59
Vanguard Long-Term Bond ETF (BLV): 1.37
Vanguard Intmdt-Term Trs ETF (VGIT): 1.35
Vanguard Utilities ETF (VPU): 1.30
Vanguard Interm-Term Bond ETF (BIV): 1.29
Vanguard Tax-Exempt Bond ETF (VTEB): 1.26
Vanguard Total Bond Market ETF (BND): 1.24
Vanguard Long-Term Corporate Bd ETF (VCLT): 1.23
Vanguard Mortgage-Backed Secs ETF (VMBS): 1.21
Vanguard Interm-Term Corp Bd ETF (VCIT): 1.21
Vanguard Total International Bond ETF (BNDX): 1.20
Vanguard Emerging Mkts Govt Bd ETF (VWOB): 1.20
Vanguard Short-Term Bond ETF (BSV): 1.13
Vanguard Consumer Staples ETF (VDC): 1.13
Vanguard Real Estate ETF (VNQ): 1.11
Vanguard Short-Term Treasury ETF (VGSH): 1.11
Vanguard Global ex-US Real Est ETF (VNQI): 1.10
Vanguard Short-Term Corporate Bond ETF (VCSH): 1.10
Vanguard FTSE Emerging Markets ETF (VWO): 1.10
Vanguard Communication Services ETF (VOX): 1.09
Vanguard Short-Term Infl-Prot Secs ETF (VTIP): 1.08
Vanguard Energy ETF (VDE): 1.07
Vanguard FTSE Europe ETF (VGK): 1.07
Vanguard FTSE All-Wld ex-US SmCp ETF (VSS): 1.05
Vanguard FTSE All-Wld ex-US ETF (VEU): 1.05
Vanguard Total International Stock ETF (VXUS): 1.05
Vanguard Health Care ETF (VHT): 1.05
Vanguard FTSE Pacific ETF (VPL): 1.05
Vanguard Information Technology ETF (VGT): 1.04
Vanguard Financials ETF (VFH): 1.04
Vanguard FTSE Developed Markets ETF (VEA): 1.04
Vanguard Russell 2000 Value ETF (VTWV): 1.04
Vanguard S&P Small-Cap 600 Value ETF (VIOV): 1.04
Vanguard S&P Small-Cap 600 ETF (VIOO): 1.03
Vanguard S&P Small-Cap 600 Growth ETF (VIOG): 1.03
Vanguard Materials ETF (VAW): 1.03
Vanguard Russell 2000 ETF (VTWO): 1.03
Vanguard S&P Mid-Cap 400 Value ETF (IVOV): 1.02
Vanguard Russell 2000 Growth ETF (VTWG): 1.02
Vanguard Small-Cap Value ETF (VBR): 1.02
Vanguard Small-Cap Growth ETF (VBK): 1.02
Vanguard Industrials ETF (VIS): 1.02
Vanguard Consumer Discretionary ETF (VCR): 1.02
Vanguard Small-Cap ETF (VB): 1.02
Vanguard S&P 500 Growth ETF (VOOG): 1.01
Vanguard Mega Cap Value ETF (MGV): 1.01
Vanguard Mega Cap Growth ETF (MGK): 1.01
Vanguard Dividend Appreciation ETF (VIG): 1.01
Vanguard S&P Mid-Cap 400 Growth ETF (IVOG): 1.01
Vanguard High Dividend Yield ETF (VYM): 1.01
Vanguard S&P Mid-Cap 400 ETF (IVOO): 1.01
Vanguard Extended Market ETF (VXF): 1.01
Vanguard S&P 500 Value ETF (VOOV): 1.01
Vanguard Total World Stock ETF (VT): 1.01
Vanguard Mid-Cap Value ETF (VOE): 1.01
Vanguard Russell 1000 Growth ETF (VONG): 1.01
Vanguard Value ETF (VTV): 1.01
Vanguard Growth ETF (VUG): 1.01
Vanguard Mid-Cap Growth ETF (VOT): 1.01
Vanguard Russell 1000 Value ETF (VONV): 1.01
Vanguard Mid-Cap ETF (VO): 1.01
Vanguard Russell 3000 ETF (VTHR): 1.00
Vanguard Mega Cap ETF (MGC): 1.00
Vanguard Large-Cap ETF (VV): 1.00
Vanguard Russell 1000 ETF (VONE): 1.00
Vanguard S&P 500 ETF (VOO): 1.00
```

Some takeaways:

**1) The power of long-term bonds as a diversifier for equities is WAY more powerful than most people realize**. The top two funds (EDV and VGLT) are far ahead of the rest of the pack, highlighting the importance of including long-term bonds in the portfolio if your investment horizon is sufficiently long.

**2) Utility stocks are an unsung hero of diversification.**They have sufficiently low correlations with other stock sectors and sufficiently high variance to be powerful, especially when you consider that most broad indexes hold very little utility stocks. Even a 10% allocation to a utility sector index ETF can improve the diversification of a 3- or 4-fund portfolio. Another 10% in small-cap value helps too.

I saw another interesting phenomenon when I plotted each fund on an X-Y graph: correlation with VTI is on the X axis and diversification level is on the Y axis.

The equity funds (mostly in the lower right in blue, with correlations over 0.50) and the long-term bond funds (mostly the blue dots with correlations below 0.40) ended up on an "efficient frontier" of sorts with a polynomial shape. I added a trend line to illustrate it, and the polynomial is related to the formula for covariance.

The short, intermediate, and total bond funds (illustrated in orange) generally fall well below this frontier. Despite have a low correlation with equities, they have insufficient variance to be effective diversifiers. This a way of visualizing the well-described fact that adding longer-term bonds, which many people think of as riskier, to an equity portfolio can actually produce an overall portfolio variance that is

*lower*than if short-term bonds were used in the same proportion.