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ETF Specialist

Digging Deeper When Measuring Diversification

Even concentrated funds can be diversified.

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A version of this article appeared in the February 2017 issue of Morningstar ETFInvestor.

An index fund that follows a well-constructed benchmark and levies a low fee is usually a winning proposition. Market-cap-weighted indexes are particularly attractive, given that they outsource the work of price discovery to active market participants and tend to have low turnover. Market-cap weighting typically works best in those cases where an index is broadly diversified--as in the case of a total U.S. stock market index, for example. But market-cap weighting a smaller investment opportunity set, such as a sector, can create a concentrated portfolio and thus may introduce a greater level of stock-specific risk. So how should investors evaluate a concentrated fund's level of diversification, or lack thereof?

Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.