How to Plug the Holes in Your Portfolio

These days, lots of financial products claim to give you complete coverage of a particular type of investment. But when you take a closer look, you might realize that you're not always getting everything you think you are.

It's (not) all in the index
For investors seeking simple ways to invest in a diversified portfolio of stocks, index funds and ETFs are some of the most useful investments you can find. In a single investment, you can gain exposure to hundreds of different individual stocks or other securities. That can give you the peace of mind of knowing that even if you don't have a huge amount of money, you still don't have to worry about a particular piece of company-specific bad news doing an inordinate amount of harm to your portfolio.

But an index fund is only as good as the index it tracks. And as it turns out, many indexes have holes that you might not suspect are even there. If you really want full exposure to every stock that meets your criteria, then you'll need to look beyond the most popular index funds for ways to fill in the gaps.

Hole No. 1: Where's Canada?
For instance, take the iShares MSCI EAFE Index ETF (NYSE: EFA  ) . It follows the MSCI Europe, Australasia, and Far East index of international stocks, which many investors use to give themselves wide-ranging global equity exposure. The index tracks developed economies, so most investors understand that they need an emerging-market ETF if they want an all-inclusive international portfolio.

What many people don't understand, though, is that the index excludes not just U.S. stocks but all North American stocks. That means Canada gets left out of an ETF tracking the MSCI EAFE index. That's been bad news recently, as the Canadian stock market has grown at a much faster rate than most markets in Europe and Asia.

To plug the gap, one option is the iShares MSCI Canada ETF (NYSE: EWC  ) , which focuses exclusively on Canadian stocks. With a total market capitalization of around $2 trillion, Canada represents roughly 4% of world stock value, so use that figure to decide how big your Canadian stock position should be.

Hole No. 2: Missing large caps
The S&P 500 purports to represent the cream of the crop of American stocks. Yet because of the factors it requires for inclusion, the index leaves out some big companies.

Recently, Standard & Poor's remedied this, adding rising stocks such as Netflix and F5 Networks to take the place of smaller, fading companies such as Eastman Kodak and New York Times. But even so, Las Vegas Sands (NYSE: LVS  ) , with a $30 billion market cap, isn't part of the index. Neither is the similarly large agricultural chemical maker Mosaic (NYSE: MOS  ) , nor $10 billion airline Delta Air Lines (NYSE: DAL  ) .

The key lies with understanding what makes an S&P 500 stock. It's not just about market cap; a stock also has to have an established history and fit well into the overall framework of the other stocks. So if you really want all of the biggest stocks in the market, you need to stay alert for omissions from the S&P 500.

Hole No. 3: What's an emerging market?
Emerging markets are all the rage, and the iShares MSCI Emerging Markets ETF (NYSE: EEM  ) and Vanguard Emerging Markets Stock have become quite popular lately. But these funds might not give you as broad-based exposure to all emerging markets as you want.

Take the iShares ETF as an example. Nearly half of its assets are invested in the four BRIC countries, with much of the remainder in Asian Tiger economies such as South Korea and Taiwan. That's fine if you like those countries, but if you want to go beyond them, you're mostly out of luck.

Some investors are now looking at so-called frontier markets -- emerging markets that have largely escaped the eye of international investors. The Guggenheim Frontier Markets ETF (NYSE: FRN  ) invests primarily in countries such as Chile, Egypt, and Colombia. Those markets aren't among the most popular, yet they've provided some strong returns in the short time the fund has been open.

Know what you own
With so many financial products out there, it's more important than ever to know what's actually in the investing vehicles you own. By being aware of any omitted stocks, you can make sure your portfolio doesn't have any unsightly gaps that could hurt your long-term performance.

Fool contributor Dan Caplinger always searches for the complete solution. He owns shares of Vanguard Emerging Markets Stock, iShares MSCI Emerging Markets, and iShares MSCI EAFE ETFs. Netflix is a Motley Fool Stock Advisor pick. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy doesn't let anything nasty get through.


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