In many instances, ETFs have allowed more active investors to change their strategy for allocating assets and alter the manner in which they seek to generate alpha. Instead of seeking to identify undervalued companies through detailed analysis of financial statements, many now implement a more high level approach that includes identifying sectors, regions, or even general asset classes that will outperform in the short- to intermediate-term.
ETFs are ideal for such a strategy because of the immediate diversification they provide; spreading assets across dozens or even hundreds of individual securities will generally allow investors to minimize exposure to any one company. But there are, of course, a number of exceptions. The suite of HOLDRS products from Merrill Lynch can become concentrated because companies that are acquired or go bankrupt are not replaced [see Five Facts About HOLDRS Every Investor Should Know]. Even beyond HOLDRS, a number of popular ETF products feature heavy allocations to one or two securities, making the performance of the theoretically broad-based fund dependent on a small number of companies.
When evaluating a potential ETF investment, it’s important to consider the composition of the underlying index and the methodology used to assign weightings to individual holdings. Benchmarks that utilize market cap weighting strategies have the potential to result in a heavy concentration of holdings in a handful of stocks–something that is less than desirable for those who value true diversification and elimination of any company-specific risk. Below, we highlight five such funds [for more ETF insights, sign up for our free ETF newsletter]:
- Select Sector Energy SPDR (XLE): This popular energy ETF has about 40 holdings in total, but two companies make up nearly a third of assets: ExxonMobil (19%) and Chevron (14%). XLE’s top ten holdings make up about 65% of total assets.
- iShares MSCI Spain Index Fund (EWP): This ETF, a popular way to play the beleaguered Spanish equity market, actually gives major allocations to two companies that do significant business in Brazil: financial giant Banco Santander (25% of assets) and Telefonica, S.A. (17%). The top ten holdings of EWP make up more than three quarters of total assets.
- S&P GSCI Commodity Indexes Trust (GSG): This fund is a popular option for investors looking to establish exposure to commodities, but before investing it’s important to take a look at the underlying index. Although GSG offers exposure to five sectors of the commodity market–energy, agriculture, industrial metals, livestock, and precious metals–the benchmark to which this fund is linked maintains a heavy tilt towards energy commodities. Currently, about 66% of exposure is to oil & gas commodities, with the remainder spread across other non-energy commodities.
- MSCI Israel Capped Investable Market Index Fund (EIS): This ETF offers exposure to one of the world’s most unique economies, and in doing so maintains interesting sector exposure. EIS’s largest holding is pharmaceutical giant Teva, which makes up a whopping 21% of total assets. EIS maintains about 80 individual holdings, suggesting an impressive level of diversification. But the five largest make up about 50% of assets, suggesting that the fate of this fund rests on a few individual stocks.
- MSCI Brazil Index Fund (EWZ): One of the most popular ways to establish exposure to South American stocks, EWZ seeks to replicate a cap-weighted index comprised of the largest Brazilian companies. Similar to the Israel ETF, EWZ invests in about 80 individual securities, ensuring impressive breadth of holdings. But the depth of holdings may be lacking somewhat, as two companies account for about a third of total assets: state-owned oil giant PetroBras (17%) and mining firm Vale (16%).
The level of concentration offered by the aforementioned ETFs certainly doesn’t mean that they should be excluded from a portfolio or discarded as options for making a strategic play on a specific region or sector; in many cases, the weighting methodologies employed will work in favor of investors. But assuming that a potential ETF investment will provide the level of diversification desired may not always be safe–diversification is a sliding scale, and some funds offer much more balanced exposure than others [use the Stock Lookup Tool to find ETFs with exposure to a specific stock].
Disclosure: No positions at time of writing.