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How diverse are your ETF Investments?

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By John Beveridge - 
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Diversification has been one of the hallmarks of good investing for a long time and has also been one of the many reasons behind the rapidly increasing popularity of index tracking Exchange Traded Funds (ETFs).

There have been a lot of smug ETF investors – myself included – who have waxed lyrical about the instant diversification provided by ETFs that cover the ASX 200 and also for bigger indices such as the S&P 500.

Simply put, such ETFs offer a diversification across companies on the relevant exchange that would be impossible to match by buying even a large number of shares in individual companies.

While Australian investors have long had to live with concentration risks due to the heavy concentration of miners and banks at the top of our league tables, a similar situation has rapidly developed in the US as well.

It has become such an issue that it demands the attention of passive and active investors alike and might also demand some changes to how they invest.

S&P 500 becomes more concentrated

It is now 20 years since Artificial Intelligence (AI) chip maker Nvidia replaced Enron in the S&P 500 but recent rapid price rises have caused a real problem of concentration risk even on a massive index such as this.

Looking at the numbers, at the end of 2022 Nvidia made up just 1.1% of the iShares S&P 500 ETF but that has now leapt to an amazing 6.3%.

Over that same period Nvidia jumped from just 3.3% of a Nasdaq 100 ETF such as the Nasdaq 100 ETF (ASX: NDQ) to 8% now.

The problem is not just confined to the US.

In Europe, weight loss drug maker Novo Nordisk has jumped from just 2.4% of iShares popular Australia listed Europe ETF (ASX: IEU) to 4.2% now.

The concentration problem is even more pronounced if you look at the concentration of various sectors that make up a given index.

Concentration by sector an issue as well

Looking at the S&P 500 again, if we isolate all of the massive technology companies such as Meta, Apple, Microsoft, Nvidia, Alphabet, Amazon and Tesla they now make up a much larger chunk of the S&P 500 than they used to.

Indeed, the tech sector now accounts for a massive 30% of the benchmark index, which is more than the next two largest sectors combined—healthcare and financials.

With an even broader definition of technology, some even argue that the S&P 500 is now made up of 40% technology dependant companies.

At one level this is not too much of a problem – after all, technology and weight loss companies have been fantastic contributors to growing these indexes and also the size of portfolios composed of simple, low-cost ETF products that many Australians hold.

What happen if technology falls?

The problem emerges if you think about what might happen if, for some reason, technology companies suddenly become less appealing and their value begins to shrink.

This is not an impossible thought – the tech wreck between March 2000 and October 2002 saw the NASDAQ index fall from 5,048 points to just 1,139 points, neatly erasing just about all of the impressive gains made during the dot-com bubble.

I’m not suggesting that will happen again and certainly this time around a lot of the technology companies are built on a much broader and more profitable foundation than the days of the unprofitable dot-com companies.

Rising concentration risk can lead to underperformance

However, the analogy holds that as concentration risk increases, so too does the risk of sustaining losses or underperformance should a very dominant sector start to do badly.

Just a simple mean reversion in which the much-hyped technology companies moved back to occupy the same slice of the index they did a few years ago would cause a massive negative change on the index and is an investment risk it would be foolish to ignore.

After all, even a hero stock such as Nvidia has been volatile in both directions, with the share price more than halving three times in its 20-year history on the S&P 500.

Thankfully, there are some solutions to the problem of market concentration that should be familiar and fairly easy to implement.

Rebalancing for the win

The concept of rebalancing is a familiar one to most fund managers but it is sometimes a discipline that personal investors ignore.

The basic premise is that you start out with some basic parameters and at certain times – say annually – you review the portfolio and look to rebalance it to bring it back into line with the original asset allocation.

Imagine, for example, that over the past year your portfolio was split 40% offshore shares and 40% Australian shares.

Given the outperformance of the US market and also some other markets such as Europe and Japan, your portfolio has probably moved a fair way out from those original objectives.

To rebalance, in that case, you would probably be selling down some of the outperformers such as US and European shares and reassigning the resultant cash into Australian shares or emerging markets, for example.

It might also be prudent to assign more to cash or bond investments if that proportion has fallen.

It is also possible to make dynamic changes to the asset allocation to react to market situations – perhaps increasing the allocation to cash and bonds if shares seem overvalued, for example.

Such rebalancing doesn’t entirely get rid of the issue of concentration of individual exchanges but it does ensure that should there be some mean reversion or falls in technology stocks for example, the effect on your overall portfolio is reduced because you have sold down a little near the valuation top.

Rebalancing can be a difficult discipline for investors to master but it is an important one to develop.

It is also a good idea not to change your rebalancing date or frequency on a whim – come up with a time when it should be completed and get it done.

Without rebalancing, over time you can end up in the familiar position of having a progressively more concentrated portfolio.

Would you be happy, for example, to eventually have 90% of your money riding on the US market?

Or, for a direct active investor, to find that one company that has performed exceptionally well now makes up 80% of your equities portfolio?

Once you get to that position it is much more difficult to address but by rebalancing more often, such imbalances occur much less often.

Diversify

There are still other ways to diversify away from the concentration within a particular index.

One possibility is to use an equal weight ETF which effectively counteracts the situation in which one stock or sector gets so big it starts to dominate an index.

Effectively this works by actively rebalancing the portfolio over time and can produce quite different outcomes to the “raw” index, which is naturally biased towards larger companies.

One way of employing this would be to add the equal weight ETF to the allocation for that index, reducing the overall concentration problem but retaining direct exposure to the index as well.

That is a good approach because it allows for a situation in which one sector wanes and another rises to take its place.

Of course, this would require you to make a decision as to what proportion of the S&P 500, for example, should be raw and what proportion equal weight.

However, if you want to move from a more passive approach to becoming more active, it is going to necessitate making decisions.