Like many investors, I’m a big fan of exchange-traded funds (ETFs), especially because they combine the best features of stocks and mutual funds. When I invest in a particular company, I only own its shares. When I invest in an ETF, I own a diversified portfolio of stocks from many companies. Buying an ETF is like buying an entire basket of high-yield investments, thus diversifying my portfolio.
However, there is an inherent danger in believing that you are diversifying your portfolio by simply putting your money in ETFs.
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When diversified is not diversified
Investing in multiple ETFs can create an illusion of diversification while creating greater risk, unnecessary costs, and a portfolio that may be more complex but not safer.
Here’s why: The most popular ETFs may have different names, but that doesn’t mean they have different holdings. In fact, you could buy two or three different ETFs and barely get diversification because each one has overlapping stocks.
How overlap occurs
There are a few reasons why different ETFs end up with the same underlying holdings:
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It’s common for stock ETFs to track broad indices that include the same companies at the top. For example, large US technology companies often dominate several indices.
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Along the same lines, sector or thematic ETFs, such as those focused on technology, healthcare or innovation, tend to hold many of the same high-profile growth stocks.
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Even different types of stock funds with different labels can end up owning many of the same large, popular companies.
The main danger of overlap
Let’s say you are committed to diversifying your portfolio and decide that the best way to do so is to buy the Vanguard S&P 500 ETF (NYSEMKT:VOO) and iShares Core S&P 500 ETF (NYSEMKT: IVV). You feel pretty good about it: the former owns 505 shares and the latter 504 (as of June 11).
But there is a problem. Both ETFs track the S&P 500and because they follow the same index, their top holdings, including NVIDIA, Appleand microsoft They are identical.
Because ETF baskets and portfolios carry the same market and category risks as their underlying securities, overlapping holdings concentrate rather than spread risk.