While it feels good to correctly time a particular market segment, investors should not overlook the diversification qualities of holding a broad, index-based exchange traded fund, especially with the recent dip in momentum stocks.
A lot of investors fail to recognize that the diversification benefits of index ETFs are diluted if the investment is just a variation of a single theme, writes John Prestbo for MarketWatch.
For instance, tech and biotech ETFs both declined as their respective sectors fell on weakness from Facebook (NasdaqGS: FB) and Gilead Sciences (NasdaqGS: GILD). The iShares Nasdaq Biotechnology ETF (NasdaqGM: IBB) fell as much as 8.9% in the first half of April while the First Trust Dow Jones Internet Index Fund (NYSEArca: FDN) declined as much as 7.9%.
In contrast, broad market ETFs were only slightly affected. For example, the Schwab U.S. Broad Market ETF (NYSEArca: SCHB) only dipped 3.2% and the SPDR S&P 500 ETF (NYSEArca: SPY) dropped 2.9%. SCHB allocates 16.5% to tech and 12.5% to health care sectors while SPY has a 16.9% weight in tech and 13.1% in health care.
By investing in a broad index ETF, investors gain greater diversification and minimize portfolio volatility, whereas a highly concentrated ETF could overexpose an investor to sector-specific risks.
Moreover, investors should be aware of specific ETF indexing strategies. For instance, index-based momentum ETFs were also pressured in the recent sell-off. The PowerShares DWA Technology Momentum Portfolio (NYSEArca: PTF), which includes a 92.1% weight in tech stocks, fell almost 8% in the first 11 days of April.
“Indexed investing doesn’t try to beat the market, but rather seeks to get the most out of what the market offers,” Prestbo said in the article. “As Vanguard Group founder John Bogle has put it innumerable times, classic index investing consists of (1) the broadest possible diversification, sustained over (2) the longest possible time horizon at (3) the lowest possible cost, thereby assuring (4) the highest possible share of investment returns.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.