Exchange traded funds are touted for the diversification benefits they provide but specialized or targeted sector funds may not be as well-rounded as one may think. While some ETFs do provide cost efficient diversification benefits, the reward comes at the price of individual research.
“Buying an ETF instead of an individual stock doesn’t mean you can skip doing your homework. If anything, more work is required because investors should take the time to research all of the companies that are heavily represented. And if there’s any doubt, the recent impact of Apple on tech ETFs should provide ample evidence,” Daniel Putnam wrote for InvestorPlace. [Tips for Choosing the Best ETFs for Sectors]
When Apple (NasdaqGS: AAPL) shares surged past $600 per share, investors who had capital in funds such as the Technology Select Sector SPDR (NYSEArca: XLK) got ample exposure to the rally, as Apple exposure grew to 20%, reports Daniel Putnam for InvestorPlace. The result was a concentrated bet on an individual company, and investors who were unaware got slammed when the share price dropped. This is just one instance of how important it is to k now what shares an ETF holds, and what allocation each has. [Tech ETFs Wait on Apple’s Earnings]
The problem of pre-conceived diversification is not focused on the technology sector. Regional or single-country ETFs also fall victim to this over-concentration. For instance, the iShares MSCI Shouth Korea Index Fund (NYSEArca: EWY) is highly concentrated in the technology sector, with Samsung making up 22% of the fund. And the iShares MSCI Brazil Index Fund (NYSEArca: EWZ) has about 27% of assets invested in natural resources and commodity companies Petrobas and Vale.
For investors to really understand how their portfolios are allocated, it is important to look at what shares are represented in selected ETFs. Over-allocation to sectors or companies can be easy to miss and under-exposure to a desired area is also a possibility. Putnam explains that concentration risk is not necessarily a bad thing, if it is deliberate. [Patching the Hole in Your ETF Investment Bucket]
Tisha Guerrero contributed to this article.