How to diversify portfolios with ETFs?
27 MAR, 2025
Investors use diversification in an attempt to manage the overall risk of a portfolio. The key to diversification is to identify assets whose returns respond to factors that are independent of each other. By their nature, ETFs are inherently diversified, as they replicate a wide variety of indices and therefore cover a broad spectrum when incorporating them into portfolios.
The experts at Tethys, HSBC Wealth & Personal Banking and Amundi explain where to invest to diversify through exchange-traded funds.
Clément Chaulot, Director - Asset Management, Tethys
For years, passive investors have relied on MSCI World ETFs as an efficient solution for global exposure. But here’s the catch: almost ¾ of the MSCI World is now exposed to U.S. stocks. This raises two major concerns:
- Diversification risk – Is this truly global exposure? Not really.
- Valuation risk – With a forward P/E of 22, the U.S. trades at historically high multiples versus its historical average and other regions.
A shift beyond U.S. markets is overdue—but how?
Emerging Markets: High Risk, High Potential
Adding Emerging Markets (EM) is a must. Despite underperforming in recent years, they tend to outperform over the long run. The MSCI ACWI, which includes EM, improves global exposure, yet still holds 66% in the U.S.—hardly solving the problem. So what’s the move? A dedicated EM allocation through ETFs and active funds makes sense, as these inefficient markets offer strong opportunities for active managers to add value.
Small Caps: The Forgotten Alpha
Small caps have been completely overlooked after years of brutal underperformance. But history shows they outperform large caps over the long term. Today, they trade at extreme discounts—a rare entry point for investors.
Passive investors can use global small-cap ETFs, but active funds also have a role to play. As with Emerging Markets, small caps remain one of the rare segments where active managers can generate real alpha.
The Value Play: A Contrarian Bet?
With U.S. stocks at premium valuations, value investing is making a comeback. Potential plays include:
- Pure value ETFs (e.g., MSCI World Value)
- Equal-weight indices (which reduce mega-cap bias and could be particularly useful in the U.S.)
- Regional tilts (e.g., overweighting Europe, where stocks remain cheap)
That said, blindly betting on value isn’t enough. Quality remains key. U.S. large caps still dominate the MSCI World Quality Index for a reason. The best approach? Blend value with quality.
Momentum & Dynamic Allocation
What if U.S. dominance persists? The reality is, despite valuation concerns, momentum matters. A dynamic allocation strategy could include:
- Continuing to overweight U.S. equities if they keep outperforming
- Reallocating to non-U.S. markets when momentum shifts
Trump's return to the White House could prolong U.S. equity dominance, making a strict U.S. underweight a risky bet.
The Ideal ETF Portfolio
A well-structured passive portfolio should include:
- MSCI World Quality index as the core building block
- Emerging Markets & Small Caps for long-term alpha, not only through ETFs but also through active managers
- Value ETFs & European exposure to hedge U.S. overvaluation
- Momentum-driven ETFs & tactical allocation to stay ahead of trends
Passive investing isn’t just about buying MSCI World and forgetting about it. There is consistent alpha to capture by building a more granular portfolio that adapts.
Brendan Ashe, Head of ETFs and Investment Process & Praneet Battina, Senior ETF Analyst, HSBC Wealth & Personal Banking
Exchange traded funds (ETFs) have become an important tool in modern portfolio management, enabling investors to implement portfolio decisions with cost efficiency and flexibility. Core equity allocations are dominated by US large caps, but the array of products available allow investors to tactically target exposures further down the market cap spectrum or regions seen to be in favour.
Within fixed income, a distinct home currency bias is obvious. The growth of actively managed ETFs provides investors with a further tool to increase income or reduce portfolio volatility and may in some cases replace passive allocations to core exposures.
Exploring the global horizon
Looking at the equity market, investor allocations to US large-cap are largely aligned (if slightly in excess) to the market’s weighting in global equity indices. Beyond this, a significant trend in 2024 was allocations to US small- and mid-caps, with investors taking positions in anticipation of, and in reaction to the US presidential election result. We also see investors taking a similar approach to allocating to in favour regions; in 2024 a notable beneficiary of positive market sentiment was India-focused ETFs. On the other hand, the rise in popularity of Emerging Market Ex-China ETFs shows how investors can also implement decisions to exclude markets where sentiment is less positive.
Beyond the home market
While the US equity market draws investors from around the world, home bias is a much more pronounced feature of the fixed income markets. Investors continue to prefer allocating to ETFs offering exposure to fixed income instruments denominated in their home currencies. The shift in the rate environment since the Covid crisis has made it easier for investors to secure attractive yields while taking a conservative approach to risk. Reflecting this, emerging market bond ETFs, historically seen as a source of yield, saw outflows in 2024.
From passive to active
Active ETFs are now becoming a significant part of the ETF landscape with over $1tn in AUM. The development of active ETFs is a recognition by traditional managers of the value investors place on the features of an ETF wrapper, namely intra-day liquidity, continuous pricing and transparency. Similarly to the index-based market, products offering US large cap exposure dominate. To date popular offerings have included low-cost systematic strategies aiming to deliver benchmark plus returns, suggesting that investors may be looking to replace index-based strategies within their core allocations. Another noticeable trend is allocations to options-based strategies with investors seeking to increase income within portfolios or to reduce volatility by limiting losses on the downside.
ETFs were originally conceived as instruments that provide access to cheap, passively-managed core exposures. In the main, this remains the case. That said, where appropriate investors have been willing to use the extensive toolbox now to target more niche exposures tactically. The launch of actively managed ETFs has also opened-up more possibilities for investors, raising the potential for investors to replace the traditional low-cost passive core, increase portfolio income or reduce portfolio volatility.
Vinvent Denoiseux, Head of Investment Strategies at Amundi ETF
ETFs have experienced exponential growth in the last two decades, becoming an essential tool in portfolio construction for investors. The global ETF market reached $14.3 trillion in January 2025, with notable expansion in Europe, where managed assets reached $2.4 trillion, around 16.5% of the global market. The U.S. remains the largest ETF market, with $10.7 trillion, approximately 75% of the global total.
ETFs are liquid, transparent, and low-cost instruments that serve as versatile elements for portfolios. Institutional investors benefit from ETFs for their long-term exposure to risk premiums of different asset classes, allowing for effective diversification. Most ETFs publish their positions daily, providing investors with a clear view of the underlying assets. This transparency helps professional investors make decisions with full knowledge and maintain control of their investment strategies.
ETFs are traded like shares on major exchanges, offering high liquidity and the flexibility to buy and sell throughout the day at market prices. Cost efficiency is a key advantage of ETFs and is crucial for professional investors looking to maximize returns while minimizing costs. In addition, ETFs incur lower trading costs, such as commissions and bid/ask spreads, which further enhance their profitability. These features allow investors to respond quickly to changing market conditions and facilitate sector and regional rotations. For example, in 2024 there was a significant rotation towards US equity ETFs, driven by a greater appetite for risk. ETFs also facilitate access to specific sectors, commodities or investment strategies that might otherwise be difficult to access, such as emerging markets or thematic investments.
In general, ETFs are solid tools for portfolio diversification, as they combine profitability, liquidity, and access to a wide range of markets. These advantages make ETFs an attractive option for professional investors looking to optimize their investment strategies.
