The Diversified ETF of Your Dreams Doesn’t Exist. But Here’s How You Can Benefit from the Ones That Do

Investing’s holy grail is a portfolio that produces a high rate of return with little-to-no risk. Every investor wants it, but no one can find it because a trade-off exists: Investors usually have to incur more risk to earn a higher rate of return.

That’s where diversification can potentially alter the way portfolios are constructed. Ideally, the assets and exchange-traded funds holding them have high expected rates of return and low correlations to one another. Combining them in the right way can curb risk while maintaining or even slightly improving an investment portfolio’s overall return.

Yet, such asset classes, and ETFs that invest in them, don’t really exist. Those with higher expected rates of return tend to be more correlated with the global stock market, while others with lower correlations tend to have lower rates of return and less risk overall.

In other words, there are trade-offs to consider.

Not That Foreign

Foreign stocks have long been a de facto way for many investors to diversify their investment portfolio, and the basic reasoning sounds sensible. Foreign stocks expose investors to a wider and more diverse universe of stocks that are listed in different currencies, have different management cultures, and are exposed to different geographic and political risks. All that says is that they shouldn’t always perform like the broader US market, but they should still deliver a relatively high rate of return over the long haul.

Several decades ago, that was reasonably true because the correlation between foreign stocks and US stocks was fairly low. The chart below shows that correlations typically hovered around 0.4 and occasionally dipped even lower throughout the 1970s and 1980s.

It isn’t too difficult to understand why. It was much tougher to buy and sell foreign stocks 50 years ago. Access was difficult to obtain and expensive when it was available, so the movement of those stocks wasn’t always in step with the US market.

The situation changed dramatically in the 1990s. Communication through the internet and electronic trading became easier and more affordable. Access to foreign markets improved dramatically through mutual funds and then ETFs. Those developments meant a wider group of investors and traders had a much easier time pricing the risks and expectations of all globally traded stocks. The result was a much tighter connection between the behavior of US and foreign markets, and correlations between the two subsequently increased.

While modern correlations are high by historical standards, they aren’t static, either. They’ve moved around, meaning the diversification benefits of foreign stock ETFs also move around. But there’s a basic pattern. Correlations across US and foreign stocks increased during some of the riskiest periods of the past quarter century, such as the bursting of the dot-com bubble in the early 2000s, the 2008 financial crisis, and the coronavirus pandemic more recently. In other words, foreign stocks’ diversification benefit declined precisely when it was needed the most. The same observation held for emerging-market stocks.

Based on correlations alone, adding a foreign stock ETF or increasing allocations to foreign stocks hasn’t provided much of a diversification benefit. All stocks are effectively risk assets regardless of the exchange they trade on or the currency they are denominated in.

The same story extends to various strategic-beta ETFs. ETFs targeting value, low volatility, or momentum often don’t march in perfect sync with each other, but all of them have a heavy dose of the market’s risk. The chart below shows the correlations of various iShares single-factor ETFs with iShares Core S&P 500 ETF IVV over the 10 years through September 2026.

All had correlations of about 0.9 or more with the iShares Core S&P 500 ETF. Any diversification potential achieved through different strategic-beta ETFs should be relatively small because they largely move in the same direction as the market. The risk factor that each ETF targeted explained the remaining gap.

It’s Just Stuff

High correlations across foreign and domestic stocks have essentially left investors who want diversifying assets to look for them elsewhere. Commodity ETFs look like a decent alternative on the surface, but they have several drawbacks.

Commodities have been a more effective diversifier than foreign stocks in recent decades. Invesco DB Commodity Tracking ETF’s DBC correlation with the broader US stock market, as proxied by iShares Core S&P 500 ETF, was just 0.43 over the 20 years through September 2026. But $1.0 invested in it on May 1, 2006, grew to just $1.60 by the end of September 2026. Meanwhile, $1 invested in iShares Core S&P 500 ETF grew to more than $8 over the same stretch.

It isn’t hard to understand the chasm between their growth rates. Commodities are essentially stuff. Gold, oil, corn, and natural gas, among others, are the raw inputs to the finished goods and services that businesses produce and consumers purchase. They’re essential to the economy, but they aren’t businesses. They don’t have revenue and profits that can grow over time, so they’re only worth what another is willing to pay for them. As a result, their long-term total return tends to hover close to the long-term rate of inflation, or about 2%-4% annualized.

Accessing the risk/return of commodities is another hurdle that commodity-focused ETFs must overcome. The gap between commodity prices and ETF prices is minimal for ETFs that physically hold the underlying stuff. SPDR Gold Shares ETF GLD and iShares Silver Trust ETF SLV are two examples of ETFs that directly hold physical blocks of gold and silver to support their ETF’s share price.

Gold and silver are exceptions in that regard because not every commodity can be physically held by an ETF. Commodities like oil and natural gas come with substantial storage and shipping costs that prohibit an ETF from holding them directly. Others, such as those related to food and agriculture, can expire if they aren’t used within a certain window of time, which also prohibits ETFs from directly holding them in a cost-effective way.

Broad commodity ETFs typically use futures contracts to replicate the performance of their target commodities. But futures contracts don’t precisely track the spot price of their associated commodity, and they come with additional costs that eat into an ETF’s total return.

Bonds!

Bond ETFs are the third and perhaps most widely used diversifier. Their known face value and coupon payments mean they offer a lower risk/reward profile than stocks, and that translates into lower correlations. Vanguard Total Bond Market ETF’s BND correlation with iShares Core S&P 500 ETF was just 0.23 over the 20 years through September 2026. Its risk, as measured by standard deviation, was less than one-third that of the iShares Core S&P 500 ETF.

Bonds are a broad asset class; they’re much broader than those included in the Vanguard Total Bond Market ETF, which sticks to investment-grade bonds and excludes certain segments of the bond market. Many of these bonds are available through dedicated ETFs, and each type has its own diversification considerations.

US Treasuries have the least amount of credit risk. They also have the most diversification potential. The correlations between Treasury ETFs and the iShares Core S&P 500 ETF have landed among the lowest of all bond ETFs. Investment-grade corporate bonds incur incrementally more credit risk, and that strengthens their relationship to the broader stock market.

High-yield corporate bonds further amplify overall risk and correlation with the stock market. They incur more credit risk than investment-grade corporate bonds, and their correlations with the stock market suffer as a result. The track record for corporate bond and high-yield bond ETFs is a little shorter than Treasuries or the broader bond market. The chart below shows correlations between iShares Core S&P 500 ETF and ETFs tracking various cuts of the Treasury market, investment-grade corporate bonds, and high-yield bonds over the 15 years through September 2026.

Short-term Treasury bills had the lowest correlations and volatility of any bond ETF over the past 15 years. That shouldn’t come as a surprise. They have the least amount of credit risk, and they’re the least sensitive to interest rate changes. They also hammer home an important point regarding bond ETFs’ ability to curb risk: The risk-reducing abilities of bond ETFs have as much to do with their lower volatilities as their lower correlations. If the objective is to reduce risk, then short-term Treasury ETFs provide the biggest bang.

This isn’t to say that foreign stock ETFs, strategic-beta ETFs, or corporate bond ETFs should be ignored. Correlations aside, they provide other benefits. Foreign stocks expand the breadth of an investment portfolio. Strategic-beta ETFs are great for homing in on long-term drivers of total return. Corporate bond ETFs provide higher yields and can be a source of income. They all have a place for the right investor in the right circumstances.