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Are Diversification Features for ETFs Illusory?

One of the most compelling features of exchange-traded funds, which was responsible for their enormous popularity over the past decade, was that they offered mom and pop investors a cheap and easy way to diversify their investment holdings. ETFs were alluring because individuals could attain professional portfolio diversification without making the weighting or allocation decisions themselves, or paying an investment manager to make these choices.

Even though passive funds have genered impressive returns over the past decade, however, the disproportionate weighting of a few large-cap constituent stocks has eroded the diversification of many ETFs.

It should come as no surprise that the winnowing of diversification has mirrored the broader market's dependence on a handful of tech stocks, which have exerted a disproportionate impact on the valuation levels of the market. ETFs, like the overall market, benefited greatly from the tech stocks' large and unbroken price momentum.

The individual performance of a small number of stocks, most notably members (or former members) of the FANG group, as well as other tech stocks, have outperformed the market, sometimes by leaps and bounds. The impact of such outsized gains on many ETFs is that over time, these investment vehicles start to lose their highly-touted, broad-based diversification features. This is because buying and selling decisions for the portfolio is triggered by changes in the composition of the indexes they track.

Additionally, the indexes on which the ETFs are based themselves are allocated among constituent stocks, based on the market capitalization of each company in the index. If the market capitalization of any one company rises faster than the market cap of others in the index, the fund's manager rebalances the index, giving that company a larger position within the entire portfolio. Many ETFs have become top-heavy because shares of a few tech stocks are continually added to the portfolio as a result of their stellar performance.

A good example of this overweighting phenomenon is the explosive earnings growth of Microsoft (NASDAQ:MSFT). Since late 2015, shares of the software company have more than doubled, forcing many funds to add positions to their existing holdings. Microsoft now represents around 11% of the more than $70 billion in total assets in Invesco QQQ Trust (NASDAQ:QQQ) ETF, up from 8% three years ago. Even though Invesco QQQ uses a modified market cap formula to help ensure diversification, three stocks, Microsoft, Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL), still account for approximately 31% of the fund's holdings -- up from less than 25% three years ago.

It is important to note as well that while a growth ETF may have enhanced volatility because of its tech stock weighting, other funds that track a broad market index could also be subject to swings, depending on how a small grouping of stocks impacts the larger market.

Over the past decade, the FANG grouping on many occasions had the unorthodox but persistent effect of causing the broader market to increase whenever one or more of the constituent stocks posted good earnings growth.

This effect can be magnified. Since many funds use similar weightings methodologies, each of the separate funds can have very similar portfolios. Data from Morningstar indicates the same large-cap tech stocks account for four of the largest positions for eight growth-oriented ETFs. Thus, buying different growth funds from different investment managers may not necessarily solve the diversification problem.

How can an ETF investor ensure diversification?

In an era of tech stock market dominance, the best way for individual investors to attain diversification is to pair existing growth-focused ETFs with funds that focus on smaller-cap stocks. Todd Rosenbluth, head of ETF and mutual fund research at CFRA, a New York-based financial data provider, suggests investors combine iShares S&P Mid-Cap 400 Growth (IJK) and Vanguard Small-Cap Growth (VBK) as one possible option for allocating risk.

The iShares ETF holds more than 240 individual stocks, none of which represents more than 2% of its assets. This is in marked contrast to some of the larger-cap funds, whose holdings are disproportionately comprised of a few tech stocks. The portfolio of the Vanguard ETF is comprised of more than 600 stocks; no individual position is more than 1% of the fund's total portfolio value.

Investors who originally purchased ETFs with the objective of spreading risk should reassess the number and sector type of funds they now own and be prepared to make necessary adjustments where warranted.

Disclosure: I have no position in any of the securities referenced in this article.

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This article first appeared on GuruFocus.