Equity holding diversification and how to measure it

Diversification is something we consider essential but how can it be measured?

One of the simplest and easiest ways is to look at the top 10 holdings. As of the end of July, the Top 10 equity holdings of our Core portfolios were as follows:

Add this up, and you can see the top 10 positions make up only 4.9% of the equity holdings, a very small proportion of the portfolio indicating a high degree of diversification.

Our Sustainable World (ESG) portfolios are, by design, slightly less diversified given they focus on companies that provide a clear positive net benefit to the planet and society as well as in many cases explicitly excluding a number of negatively impactful sectors. The top 10 equities of Sustainable World make up 7.4% of total equity exposure and consist of the following names:

Of course, it’s useful to compare these numbers to a relevant benchmark. A capitalisation weighted global equity portfolio (in this case the Morningstar Global Markets index which is very similar to the MSCI All Country World Index) has a top 10 that makes up 14.1% of total equity exposure, significantly higher than both Core and Sustainable World:

Another way of measuring diversification is to look at the total number of holdings. However, this has some serious drawbacks.

The global equity index may have over 8,000 stocks, but most of it is made up of its biggest holdings, so the number of stocks doesn’t really indicate how diversified it is.

Consider the extreme case of a portfolio that is made up of 99% in Apple, with 1% invested across 8000 other stocks. This portfolio has a very large number of holdings, but in practice it’s not at all diversified because it’s almost completely tied to the performance of Apple.

A better way to measure how much diversification a portfolio actually has is to use the concept of “effective stocks”. The calculation is a little technical (it’s calculated as the inverse of the sum of the squared weights of the constituents of a portfolio), but basically the more diversified a portfolio, the closer its effective stock’s value is to the number of holdings. The less diversified, the closer it is to 1.

For example:

  • A portfolio of 100 equally weighted stocks each of weight 1% will have an effective stocks number of 100
  • A portfolio of 100 stocks with one having a weight of 99.01% and the other 99% having weights of 0.01% will have an effective stocks value of 1.02.

So, how do Core and Sustainable World stack up relative to the global equity benchmark in terms of effective stocks? Well, the Morningstar Global Markets index has 8,228 positions as of July but only 282 effective stocks.

Sustainable World may have only 526 equity positions overall, but because none of those positions is that concentrated it has 247 effective stocks, almost as many as the global equity benchmark.

Core, on the other hand, with its 3,074 positions has 679 effective stocks. This is more than double that of the benchmark and, in practical terms, an extremely diversified portfolio of equity holdings.