Exchange-traded funds are seen as a way to get targeted, diversified exposure to various assets, and broad-based funds such as SPDR S&P 500 ETF (NYSE:SPY) do in fact provide the kind of broad exposure investors expect.
However, many second-tier funds — particularly those that focus on individual countries and sectors — are heavily concentrated in a handful of companies. The result: Investors might be making peripheral bets that are entirely separate from their original intent.
The most well-known instance of this phenomenon occurred when Apple (NASDAQ:AAPL) surged toward $700 earlier this year. This put the spotlight on ETFs with massive weightings in the stock. In several funds, including the Technology Select Sector SPDR (NYSE:XLK), Apple grew to more than 20% of the portfolio. Investors who thought they held diversified exposure to the tech sector were in fact holding a concentrated portfolio with a built-in bet on an individual stock.
For a time, nobody was complaining. But now that Apple has plunged more than 20% in a little under two months, XLK has taken it on the chin — as have other Apple-heavy ETFs such as the iShares Dow Jones U.S. Technology Sector Index Fund (NYSE:IYW) and Vanguard Information Technology ETF (NYSE:VGT).
The recent effect of Apple on these ETFs is an indication that investors really should consider concentration risk when shopping for funds.
Single-Country ETFs: Know What You Own
Apple’s far from an isolated case, too — many regional ETFs also are heavily tilted toward a small handful of companies or a specific sector of the market.
A prime example is the iShares MSCI Brazil (Free) Index Fund (NYSE:EWZ). The common and preferred shares of Petrobras (NYSE:PBR) make up 15.3% of the fund, while the common/preferred of the iron ore producer Vale (NYSE:VALE) is another 11.8%. That means a $20,000 investment in EWZ is also a $5,420 position in these two companies, which amounts to a substantial play on natural resource stocks.
The iShares MSCI South Korea Index Fund (NYSE:EWY) is structured in a similar way, except in this case the concentration occurs in a single company — Samsung Electronics (PINK:SSNLF) — which makes up 22% of the fund.
iShares MSCI Taiwan Index Fund (NYSE:EWT), meanwhile, holds 20% of assets in Taiwan Semiconductor (NYSE:TSM) and another 8% in the contract manufacturer Hon Hai Precision Industry, with a grand total of 55% in the technology sector.
Investors will make a similar peripheral bets in iShares MSCI Hong Kong Index Fund (NYSE:EWH), which has a 62% weighting in financials; iShares MSCI Italy Index Fund (NYSE:EWI), weighted 23% in ENI (NYSE:E); and MSCI Spain Index Fund (NYSE:EWP), where nearly half of the portfolio is held in just three companies. These are just a handful of the many examples of highly concentrated ETFs in this category.
Sector ETFs Can Contain Surprises, Too
Sector ETFs, by their very nature, are non-diversified, and most investors wouldn’t have it any other way. Still, XLK isn’t the only fund whose performance is closely tied to the fortunes of one or two individual companies. Consider these weightings in a handful of some notable sector ETFs:
- Energy Select Sector SPDR (NYSE:XLE): Exxon Mobil (NYSE:XOM), 19.4%; Chevron (NYSE:CVX), 15.2%.
- Consumer Staples Select Sector SPDR (NYSE:XLP): Procter & Gamble (NYSE:PG), 13.7%; Phillip Morris International (NYSE:PM), 10.7%; Coca-Cola (NYSE:KO), 10.4%.
- Health Care Select Sector SPDR (NYSE:XLV): Johnson & Johnson (NYSE:JNJ), 12.8%; Pfizer (NYSE:PFE), 11.9%.
- Vanguard Telecommunication Services ETF (NYSE:VOX): Verizon (NYSE:VZ), 22.6%; AT&T (NYSE:T), 21.7%.
- Market Vectors Biotech ETF (NYSE:BBH): Amgen (NASDAQ:AMGN), 17.2%; Gilead Sciences (NASDAQ:GILD), 12.8%.
The ETF issuer Guggenheim has sought to address this issue through a series of equal-weight sector ETFs, but they haven’t made a dent in the bigger names in terms of either size or trading volume. However, the equal-weight sector ETFs have outperformed their market-weighted Select Sector SPDR ETF in six of nine segments in the past five years — an indication that perhaps investors should be paying more attention to the concentration issue.
The Bottom Line
Concentration risk doesn’t necessarily have to be a bad thing, but the lesson of EWZ, VOX and the other ETFs mentioned above is clear: 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.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.