Introduction

We compared the risk profiles of two types of portfolios, one based on S&P 500 stocks and the other based on exchange-traded funds (ETFs). Since many of the initially available ETFs tracked large-cap indexes such as the S&P 500, it was unclear how much total risk reduction could be achieved with portfolios of ETFs above and beyond portfolios of S&P 500 stocks. The creation of more varied ETFs, however, may provide opportunities for superior diversification. That is, the total risk of a portfolio consisting of ETFs may be lower than that of a portfolio based on the S&P 500. To test how newer ETFs have changed portfolio comparisons, we compared data from an early time period when relatively few ETFs were available to a more recent time period with a greater variety of offerings.

Our results, which are based on data from 2001 through 2007, support the idea that portfolios constructed purely of ETFs may be a cost-effective substitute for traditional portfolios comprised of stocks and bonds. Specifically, based on the available universe of investable ETFs, we found that portfolios of ETFs require roughly half as many securities as portfolios of stocks to achieve similar levels of diversification. While in practice the exact number of stocks or ETFs needed to diversify a portfolio will depend on a multitude of factors including which ETFs are selected, our results provide a guidepost to the question, “How many ETFs are enough?”

Risk reduction through the construction of equity portfolios has been a mainstay of finance theory and practice. Harry Markowitz’s original study on portfolio selection and diversification distinguished between two types of risk: undiversifiable or systematic risk and diversifiable or unsystematic risk.¹ Markowitz’s foundational work has provided the basis for numerous studies on the practical question of how many securities are required to effectively remove unsystematic risk, producing a diversified portfolio. One early study employed data for 470 securities in the S&P 500 index from January 1958 to July 1967 and constructed equally weighted, randomly chosen portfolios to estimate the relationship between portfolio size and risk.² The results indicated that the benefits of diversification were drastically diminished once a portfolio reached eight to 10 stocks.

This approach to diversification, sometimes called naïve diversification, was refined and retested by others. A similar study from a later period concluded that eight stocks were sufficient to effectively diversify a portfolio and that adding any additional securities contributed only marginally to diversification. The data showed that 40% of possible risk reduction was obtained by holding two stocks, 80% by holding eight stocks, 90% by 16 stocks, 95% by 32 stocks, and 99% by 128 stocks.³ Although a few authors have argued that more stocks were needed, perhaps even 20 to 40,⁴ most follow-up studies have confirmed and most finance texts now teach that eight to 20 stocks are sufficient to diversify an equity portfolio.⁵

While diversification of stock portfolios remains an important issue, the introduction of new financial products has opened the possibility of portfolios comprised of other types of assets. For example, a recent study on the optimal number of hedge funds needed to diversify a portfolio concluded that five to 10 funds would provide most of the diversification benefit. Other research has found substantial diversification benefits from adding multiple mutual funds to a portfolio, even when the mutual funds purported to follow similar strategies.⁶ The availability of a variety of ETFs and the ease with which they can be used to construct portfolios at low cost make them a natural tool to use for diversification. Since ETFs are a relatively new financial instrument and have yet to be studied in depth, we decided to test ETF portfolios against portfolios of stocks.

How We Constructed Our Portfolios

To compare ETF portfolios to stock portfolios and examine how the introduction of newer and more diverse types of ETFs has enabled higher levels of portfolio diversification, we collected available data provided by CSI and Bloomberg for two time periods: January 2001 to December 2003 (89 ETFs) and January 2004 to February 2007 (134 ETFs). This difference in number of funds is due to the relatively small number of ETFs available during the earlier period and the growing number of ETFs after 2003.

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