A question of diversification: Why do ETFs also harbor cluster risks

Don't put all your eggs in one basket: This rule is one of the most important when it comes to investing that index funds can follow.

A question of diversification: Why do ETFs also harbor cluster risks

Don't put all your eggs in one basket: This rule is one of the most important when it comes to investing that index funds can follow. But even world indices harbor a cluster risk.

The same rule applies on the stock exchange as in life: If you put everything on one card, you can lose everything. "If all the money is only in one stock corporation, the risk increases that the entire investment will be gone in the end," says Niels Nauhauser, investment expert at the Baden-Württemberg consumer advice center. This is the extreme example.

Investing in two companies already reduces the risk. The wider the money is spread, the less likely it is to lose it all. That's why experts and consumer advocates like Nauhauser recommend index funds, so-called ETFs, for many savers.

Anyone who buys shares in it is investing their money in many companies at once. However, it depends on the selection of the ETF. "With some index funds, the risk is not spread as widely because, for example, they invest in stock companies from just one industry or region," says Nauhauser. For example, anyone who buys an ETF on renewable energies or with a focus on the pharmaceutical industry brings a cluster risk back into their portfolio.

Although investors spread their investment across several companies, they are dependent on the development of just one branch of the economy. If the industry is doing badly, all companies usually suffer. The standard recommendation is therefore to buy shares in a globally diversified ETF. For example, on the MSCI World index or its counterpart FTSE Developed Countries.

But even there, a cluster risk cannot be completely avoided, say critics. For example, over 1,500 companies were included in the MSCI World Index at the end of October, but around 70 percent of them came from the USA, as the MSCI product data sheet shows.

The distribution is similar for the provider FTSE. "It's a disproportionate investment in a country and a currency, and therefore riskier than diversifying even further," says Martin Weber, senior professor at the University of Mannheim's business administration faculty.

The reason the indices are composed is that they tend to select by market capitalization. The larger the stock market value of a company, the larger the company's weight in the index. What bothers Weber, among other things, is that entire regions of the world are ignored because only developed industrialized countries are taken into account.

For example, Chinese companies are not in the well-known world ETF. "Emerging market companies aren't there, but why not invest there?" he asks. This would eliminate part of the cluster risk.

Another criticism is the focus on technology companies. The four companies Apple, Microsoft, Amazon and Google's mother Alphabet alone account for more than 12 percent of the entire index. Investors have benefited enormously from this concentration of risk in recent years, reports Weber. "There has been strong development in the USA in recent years, and tech stocks have also made profits. Of course, such upward fluctuations are always great."

But since the beginning of the year, the MSCI World has lost significantly - also because the technology giants are weakening. Facebook, Amazon and Google recently announced savings rounds. Weber recommends weighting according to the gross domestic product of states instead of market capitalization and also including the emerging markets.

This is how the Arero fund, for example, which he helped design, does it: a mixed fund that invests in bonds and commodities in addition to equities. From Nauhauser's point of view, there is nothing fundamentally speaking against the weighting according to gross domestic product, which takes the size of economic areas as a stipulation. However, since it was launched in 2008, the Arero fund has recorded significantly less growth in value than an ETF on the MSCI World, he criticizes.

Nauhauser therefore recommends keeping it simple and takes a stand for the well-known world indices: "I don't see a large concentration of risk. There is also a good reason for the weighting according to market capitalization." He refers to a study by Arizona State University. It found that over a long period of time, the largest companies were primarily responsible for a positive return on the US stock market.

But if you like, you can diversify your investment a bit more, according to the consumer advocate. It is possible, for example, to put some of the money into an ETF that invests in the emerging markets. Some world ETFs also include these, albeit with very little weighting. For example the MSCI All Country World or the FTSE All World.

It would also be conceivable to add small caps, i.e. the titles of small companies. There are also special index funds for this. However, both experts advise against one thing: the so-called Equal Weight ETF. There, all stocks shown have the same weighting, regardless of whether the company is large or small.

As a result, the scatter is greater. But the economic power of the companies is not shown in a meaningful way, criticizes Weber. And Nauhauser says: "For decades, fund managers with active funds have been trying to beat the MSCI World Index, but they haven't succeeded."