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Your 'Diversified' ETF Might Now Be Anything But -- Journal Report

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09/08/2019 | 08:28pm EDT

By Michael A. Pollock

One of the biggest selling points of many exchange-traded funds is that investors can get a diversified portfolio with one click.

But some of these ETFs aren't nearly as diversified as investors may believe.

That's because the individual performances of strong stocks such as Microsoft Corp., Apple Inc. and Amazon.com have clobbered the performance of the broader market, and thus have become ever-bigger holdings for many ETFs. This is particularly true for funds that focus on the fastest-growing big companies. The result: "Broad" ETFs are less and less diversified.

That may surprise many investors, since ETFs are supposed to mirror the market. But what they may not realize is that in these funds, buying and selling is triggered by changes in the composition of the indexes they follow, not the latest news about a stock or whether it has become cheaper or more expensive compared with others.

And the indexes themselves are divvied up according to the market value of each company's shares -- its so-called market capitalization. While market cap has risen for many companies in the long bull market, it has increased more sharply for a handful of large-cap tech companies. So everything has gotten top-heavy.

As a result, ETFs have repeatedly added to their holdings in those giant companies, making the funds' overall performance more sensitive to up or down moves in those stocks while reducing portfolio diversification. For an ETF investor, that means "you're taking on additional risk, but it's not necessarily going to get you higher returns," says Alex Bryan, director of passive-strategies research at fund-trackers Morningstar Inc.

The Securities and Exchange Commission has noticed. It recently advised fund firms to notify shareholders if the size of positions in ETFs and other index-based funds exceeds limits set by law for funds labeled as "diversified."

To better understand why ETFs are getting so out of whack, and what investors can do about it, here are some answers to questions that investors should be asking.

1. How are ETFs getting out of balance?

While some ETFs use alternative approaches, most growth-focused funds track indexes based on market capitalization, a figure that represents a company's share price times the total number of its shares outstanding. If any company's market cap rises faster than the market caps of other companies in it, it automatically gives that company a larger position in it. (And if a company sells more shares in itself, a fund manager has to buy more shares to keep up with that stock's expanding presence.)

Since mid-2016, shares of Microsoft have more than doubled in price, boosting its market cap and leaving many ETFs with increased holdings in the company. Microsoft now represents around 11% of the more-than $70 billion in total assets in Invesco QQQ Trust (QQQ) ETF, up from 8% three years ago. And although the growth-focused ETF uses a modified market-cap approach that is designed to prevent it from becoming too unbalanced, three stocks -- Microsoft, Amazon and Apple -- represent around 31% of its holdings, up from less than 25% three years earlier.

Investors in QQQ still get more diversification by owning the ETF than they might by buying several individual stocks, since the portfolio also contains about 100 other stocks that provide exposure to fast growing-companies in such industries as consumer products and health care. Investors "inherently" should expect more volatility from a fund such as QQQ than from an ETF tracking a broad market index, although depending on what is driving markets, either could be more volatile than the other, says Ryan McCormack, Invesco's strategist for QQQ. Regardless of day-to-day movements, the fund's returns -- up more than 24% so far this year -- "have spoken for themselves," he says.

2. Does a little less diversification matter?

In a fund that holds dozens of securities, the impact of having 6% of its portfolio in any one stock instead of 4% may be small. But some of the most widely held large-cap tech stocks, such as Google parent Alphabet and Facebook, have traded lower in tandem on news that government agencies may seek tighter regulation of large-cap tech firms, as well as on days when investors were shifting to stocks seen as more defensive.

And because they use similar weighting approaches, ETFs can end up with similar portfolios. The same large-cap techs represent four of the largest holdings for eight big ETFs that emphasize growth, data from Morningstar Direct show.

Owning several growth-focused funds could cause hefty exposure to large-cap tech, says Jeffrey DeMaso, who co-edits a newsletter for Vanguard investors and is research director at Newton, Mass.-based Adviser Investments LLC. "An investor may think his portfolio is diversified because he owns ETFs from different fund companies," he says. "But really, they all own a lot of the same stocks."

3. Where does the SEC come in?

Federal law governing investment companies says that to be labeled as "diversified" by its sponsor firm, an index-based fund must maintain certain size limits on individual holdings. Among the rules, the total of individual positions larger than 5% can't exceed 25% of overall assets.

In June, attorneys representing the fund industry asked the SEC's Investment Management Division for assurances that its staff wouldn't recommend enforcement action against funds that weren't in compliance.

In response, the SEC said it would permit funds, in certain circumstances, to exceed the limits without shareholder or board approval if a fund did that to track its index. However, it said funds would have to update their registration statements to disclose the ability to exceed diversification limits and the associated risks, and firms would have to notify shareholders about the change in policy.

4. Have ETF sponsors changed policies?

Vanguard Group said in recent regulatory filings for Vanguard S&P 500 Growth Index (VOOG) and Vanguard Russell 1000 Growth Index (VONG), "The fund may become nondiversified, as defined under the Investment Company Act of 1940, solely as a result of a change in relative market capitalization or index weighting of one or more constituents of the Index."

Charles Schwab Investment Management has modified the diversification disclosures for its Schwab U.S. Large-Cap Growth ETF (SCHG) and Schwab U.S. Large-Cap Growth Index Fund (SWLGX) and notified shareholders by mail and on its website. Schwab said it also provides information to investors on how they might consider using alternative strategies to market-cap-weighted funds to get additional diversification. It added, "The one thing investors should keep in mind is that changes in market cycles can impact the diversification of alternative weighted funds as well, so investors should always pay close attention to what they own."

A lot of SPDR ETFs are classified as nondiversified, says Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors, meaning that they aren't subject to the same regulatory position limits as diversified funds. However, he added that the distinction between diversified and nondiversified is "really in the eyes of the SEC" and doesn't represent what constitutes being properly diversified in mitigating single-stock risk. Mr. Bartolini adds, "It's not really something investors need to fret over, but it does underscore the need for due diligence concerning any strategy."

5. How is it possible to get growth with better diversification?

Investors concerned about concentration in a large-cap fund could pair that holding with funds that focus on smaller-cap stocks, says Todd Rosenbluth, who heads ETF and mutual-fund research at CFRA, a New York-based financial-data provider.

He cites iShares S&P Mid-Cap 400 Growth (IJK) and Vanguard Small Cap Growth (VBK) as possibilities. The iShares fund recently held more than 240 individual stocks, none of which represented more than 2% of its assets. The Vanguard ETF has its portfolio spread across more than 600 stocks, and no individual holding recently was larger than 1%.

Brian Pirri, a principal at New England Investment & Retirement Group in North Andover, Mass., sometimes combines Invesco's QQQ ETF with broader funds to spread risk. Among other ETFs he uses: Invesco S&P 500 Equal Weight ETF (RSP), which weights its holdings so that none represents more than about 0.3% of the portfolio.

Mr. Pirri says investors should have exposure to strategies besides growth and should tweak the portfolio occasionally to maintain diversification. "I don't make big bets on any one particular sector," he says.

Mr. Pollock is a writer in Pennsylvania. He can be reached at reports@wsj.com.

Stocks mentioned in the article
ChangeLast1st jan.
DJ INDUSTRIAL -0.59% 26935.07 Delayed Quote.15.47%
NASDAQ 100 -0.99% 7823.553294 Delayed Quote.24.83%
NASDAQ COMP. -0.80% 8117.674437 Delayed Quote.23.32%
S&P 500 -0.49% 2992.07 Delayed Quote.19.36%
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