Introduction:
This will be a short post regarding the weighting of individual securities in an ETF and taking the implications of that into consideration. ETFs can often be associated with security due to their large number of holdings, it is seen as an indicator for reduced risk, but something that needs to be considered more is this – are all your holdings being weighed equally, why/why not?
Weighting Matters and How It Will Increase/Decrease Your Risk Exposure:
An important consideration is that the “diverse” ETFs or funds may not be as diversified as you think when the weightings of individual securities are taken into account. Let’s take a very popular ETF as an example: QQQ.
QQQ is very popular market-cap-weighted (larger companies are given more weight more than smaller ones) tracking the NASDAQ 100 index. Because of this weighting system, the top 8 of the stocks in QQQ have a much more significant impact to the growth or decline of the ETF than the other 92! Technology stocks alone make up over 50% of QQQ, so how diversified are you really when over 50% of your potential portfolio is dependent on how well the largest 8 tech companies are doing?
The way to minimize your risk to one particular sector or from ETFs that are overweight on several stocks would be to simply search for equal-weight funds (funds that give equal weighting to large/smaller companies), or funds that are simply more broadly diversified than the NASDAQ-100. However be aware there are also plenty of arguments against these funds. For example, you limit your upsides potential, or you give more weight to potential bad apples since all companies are not created equal.
Regardless the point here is, if you are looking for diversification/security, then, the most important thing is exposure to different sectors so that your portfolio isn’t subject to the exact same risks. (Tech / Oil / Subway) Not all market sectors move in tandem, the tech sector has done incredibly well over the past year, however, it is dangerous to take that and project it forward into the future. It was this exact thinking that led to the 2000 tech bubble.
Final Thoughts:
This is not an argument against owning QQQ (or any similar ETFs), it simply a post regarding to how the weighting of stocks in a fund can affect performance and sector exposure. Take your risk tolerance into account, are you fine with a large percentage of your portfolio being dedicated to tech, or some other sector? If yeah then have at it, but always do you research. If not, then more broadly diversified funds like SPY or VTI will be more your friend.
There are many sites that break down the goals of ETFs and their individual holdings + weightings of those holdings. Research your funds to ensure they line up with your diversification or consolidation goals.
Thanks for reading guys, if anyone has good researching recommendations or favorite ETFs to recommend then please comment. And have a good day! (or don’t if you don’t want to, I’m not your mom, I can’t tell you what to do)
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.