You’ve heard about all the benefits of trading in exchange traded funds (ETFs), and you’re thinking about trading them. But before you start trading this nifty investment tool, a key point to keep in mind is that all ETFs are created differently, with disparate holdings, diversification and trading strategies. When it comes to ETFs, it’s not all in the name.
ETFs are disparate in that they have different rules for re-balancing of holdings, discretion of holdings, focus, etc., and some are more liquid than others. But one of the most important things you can do when choosing ETFs is to examine the holdings and their weightings to avoid surprises.
If you ignore an ETF’s holdings, you may inadvertently end up with a portfolio heavily weighted in a specific sector or area of the market. A few examples:
- The financial sector makes up a large portion of international and country-specific funds. Whether that’s bad or good is up to you – if you’ve already got an international financial fund, you may not want as heavy a weighting in a single-country ETF that has a 40% allocation to the financial sector of that country. [Regional Bank ETFs Get Back in Gear.]
- Many emerging market funds – for example, iShares MSCI Chile (NYSEArca: ECH) and Market Vectors Russia (NYSEArca: RSX) – have heavy allocations to basic materials and commodities. If you own a commodities fund, owning a few emerging market funds may give you even more exposure to this market. You could potentially increase the volatility of your portfolio with an overexposure like this.
Some ETFs may have more equal weightings, with each company in the fund’s portfolio accounting for only a small percentage of the overall fund portfolio. However, other ETFs may have a few companies that make up a large portion of a fund’s portfolio – some ETFs may include 50% of holdings in their top 10 securities.
For example, technology sector ETFs may weight big tech names like Apple (NASDAQ: AAPL) or Microsoft (NASDAQ: MSFT) while financial sector ETFs may favor big banks like JPMorgan Chase (NYSE: JPM) or Wells Fargo (NYSE: WFC). PowerShares QQQ Trust (NASDAQ: QQQQ) is an example: Apple is 20% of the fund. [The Ups and Downs of ETF Investing.]
The result is that the performance of the ETF may be determined by a few companies. Still, it all comes down to your personal trading style. Would you like heavier weightings in the top securities, or would you prefer more evenly distributed components? Take the time to examine holdings, structure and goals of the ETF they are interested in for the time frame they have in mind. [How to Start Buying and Trading ETFs.]
For more information on ETFs, visit our ETF 101 category. You can examine the holdings and weightings of any ETF using the ETF Resumé tab under the ETF Tools category, or by entering an ETF symbol for an ETF quote. For each ETF, you can also click on the “holdings” or “composition” tabs for more information on the fund.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.