Apple Inc.’s recent product reveals had us exploring what happens when Apple (ticker: AAPL) makes up a large part of your exchange-traded fund. Namely, that kind of so-called “overweight” can have an outsized effect on how that ETF performs.
But here’s a heads-up: ETFs can get chunky off a whole lot more than Apple.
Overweights can come in a variety of ways — a single stock, a handful of companies, an industry, a sector or even a part of the world. Regardless of how it occurs, you should be aware that it does happen, and take that into account before you buy a fund.
To clarify: That’s not a recommendation to always steer clear of overweights. Heck, sometimes it’s good to have a little extra junk in your trunk.
The trouble with overweights. Naturally, the biggest objection raised to any one stock or industry taking up a significant portion of what’s otherwise supposed to be a more mixed fund is the idea that you’re not really as diversified as you thought.
“The whole rationale for a sector ETF is the ability to make a top-down call on an entire sector rather than a bottom-up call on individual stocks,” says Charles Sizemore, the principal of Sizemore Capital Management in Dallas. “But when an ETF gets too heavily weighted in just a handful of companies, you’re effectively picking stocks, whether that was your intention or not.”
That problem can compound if you’re building a portfolio of ETFs, says Joseph LaCorte, founder and president of S-Network Global Indexes in New York.
“You might have a stock heavily weighted in a core ETF — say the S&P 500,” he says. “But then you may hold several other ETFs — a sector ETF like technology — that also include that stock. By owning both ETFs, you are multiplying your exposure to a single name.”
The problem is far from isolated in U.S. funds like those tracking the Standard & Poor’s 500 index. For instance, you often find a great number of overweights when investing overseas, says Dave Mazza, head of research for SPDR ETFs and SSGA Funds in Boston.
“What’s interesting is that in foreign markets, you find many funds are concentrated in a handful of names, sectors or industries,” he says. “For instance, you might think you’re buying Malaysia, but you might really mostly be buying three Malaysian banks.”
Sizemore says most emerging-market ETFs “tend to be heavily weighted to banks and energy,” and points to the EGShares Emerging Markets Consumer ETF (ECON) as an alternative to the norm. ECON is true to its name, too, with roughly half of the fund weighted in consumer goods stocks, and the rest in consumer stocks and technology. No guesswork there.
If you’re really looking to avoid overweights, one of the best places to look is “equal-weighted” funds that hold all of their components at roughly similar weights. The best example is the First Trust Nasdaq-100 EqualWeighted ETF (QQEW), the equal-weighted alternative to the PowerShares QQQ Trust (QQQ), which tracks the market-cap-weighted Nasdaq 100. QQEW holds 109 stocks with no single equity representing more than 1.1 percent of the fund. The QQQ, meanwhile, also holds 109 funds, but more than 13 percent of the fund is AAPL stock. And QQQ also holds other tech stocks in large percentages, including Microsoft Corp. (MSFT) Amazon.com (AMZN), Google (GOOGL) and Facebook (FB).
When you might want to tip the scales. Buying a fund that’s overweight in Apple might be a bad idea if you’re looking to hold a wide bundle of tech stocks without being overly exposed to any one company. That’s the whole goal of diversification, after all — spread your risk.
But some investors like Apple. They’re comfortable with the idea of holding a bit more of it because they think it’s a better investment than a lot of other options.
And if that’s the case, why not go with a fund that’s heavily overweight in AAPL? After all, when the stock gets a head of steam, it helps elevate funds like the Technology Select Sector SPDR (XLK).
“Apple alone makes up more than 16 percent of the XLK, and Microsoft and Google make up about 9 percent each. That’s more than an third of the ETF in just three stocks,” Sizemore says. “Now, I happen to like those stocks, and I’m currently long Apple and Microsoft. But I’ve also done my homework on both and consider both to be excellent values at today’s prices. So this is one of those times that a concentrated portfolio might not be such a bad thing.”
The most important lesson. Don’t fall into an overweight. If you’re seeking maximum diversification, look for a fund that provides that. If you’re looking for an ETF that provides heavier, more targeted exposure to some areas than others, look for a fund that provides that, advisors say.
The important thing is that you look before you invest.
“Don’t rely on a fund name,” Mazza says. “When it comes to the fund that tracks the S&P 500, you know what you’re getting. When you move to smart beta funds, sectors, industries, you need to do your due diligence.”
“Go to the provider website, look for percentage of top 10 holdings, holding names, sector breakdowns. Don’t just fall into a product because it has an interesting name or it’s the most well-known product.”
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Is Your ETF Too Fat? originally appeared on usnews.com
