Why diversified ETFs could become less broad over time

Why diversified ETFs could become less broad over time

Why diversified ETFs could become less broad over time

For many investors, ETFs promise the opportunity to get exposure to a diversified portfolio of stocks under just one ticker. But in a market where growth doesn’t occur evenly across all issuing companies, it’s becoming harder for ETF strategies to stay true to their original intention.

“[T]he individual performances of strong stocks such as Microsoft Corp. , Apple Inc. and Amazon.com have clobbered the performance of the broader market, and thus have become ever-bigger holdings for many ETFs,” reported the Wall Street Journal.

The core of the problem, as laid out in the Journal article, lies in the fact that many ETFs follow specific indices, whose compositions change according to the market capitalization of each company’s shares. The long bull market has led to a broad increase in market cap, but it has risen more sharply for a handful of large-cap tech companies. The upshot, for many ETF investors, is increased concentration in such stocks, as well as sensitivity to up and down moves in those names.

Read also: What happens when you turn market cap-weighting on its head?

“[Y]ou’re taking on additional risk, but it’s not necessarily going to get you higher returns,” said Alex Bryan, director of passive-strategies research at Morningstar.

For passive index-tracking strategies, the fact that shares in Microsoft have more than doubled in price since mid-2016 has forced an increase in the company’s weight within their portfolios. Those strategies include the Invesco QQQ Trust (QQQ) ETF, where Microsoft represents some 11% of its more-than US$70 billion in total assets — up from 8% three years ago. The growth-focused ETF’s modified market-cap approach is formulated to prevent excessive concentrations, but it still has 31% of its holdings in Microsoft, Amazon, and Apple.

Decreased diversification isn’t necessarily detrimental. Those with a focus on growth stocks have profited quite handsomely in recent years. But some of the most widely held tech stocks such as Alphabet and Facebook have also traded lower in tandem, particularly because of news that government agencies are considering tighter regulation of large-cap tech firms. A shift to more defensive stocks and assets hasn’t helped.

ETFs that follow similar weighting approaches also run the risk of developing similar portfolio profiles. Citing data from Morningstar Direct, the Journal noted that the same large-cap tech names represent four of the largest holdings in eight sizeable growth-focused ETFs.

“An investor may think his portfolio is diversified because he owns ETFs from different fund companies,” said Jeffrey DeMaso, research director at Adviser Investments LLC, who warned owners of growth-focused funds to watch out for excessive exposure to large-cap tech. “But really, they all own a lot of the same stocks.”

One way to avoid the risks that come with excessive concentration in large-cap funds is to complement them with funds that focus on smaller-cap stocks, suggested Todd Rosenbluth, head of ETF and mutual-fund research at CFRA. Another option is to use broad-market ETFs that specifically come with an equal-weight mandate, eliminating the possibility of any company or handful of companies from taking up too much of the portfolio.

 

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