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A Novel Approach to Diversification Worth Watching

Alex Bryan, CFA

Alex Bryan: Nationwide Maximum Diversification US Core Equity ETF is a new fund worth keeping on your radar. It takes a novel approach to diversification, effectively targeting large- and mid-cap U.S. stocks with low correlations with each other.

To do this, it attempts to maximize the ratio of the historical weighted average volatility of the portfolio's holdings to the volatility of the portfolio itself. This is based on the idea that diversification should reduce risk of the portfolio relative to the risk of its holdings. The ratio is larger for portfolios that hold assets with lower correlations to one another because uncorrelated risk largely offsets at the portfolio level. To mitigate active risk, the fund limits its active share to 50%, though it still behaves nothing like the benchmark.

Nationwide launched this fund in September 2017, so its live record is limited. But the performance of its index suggests that it would have held up better than the Russell 1000 Index during market downturns, as expected.

This is not a repackaged low-volatility strategy, and it isn't quite as defensive. It actually has limited exposure to most style factors. This strategy does not rely on market inefficiency or mispricing. Rather, it is designed to better capture the equity risk premium by minimizing exposure to risk that the market does not compensate--basically risk that can be diversified away.

It's hard to predict whether this fund will offer higher returns than the market over the long term, despite the strong back-tested record. But it does more effectively diversify risk. Its 34 basis point expense ratio is a bit high, but overall this is a promising strategy worth watching.