One of the reasons why investors have been drawn to exchange-traded funds is that they can give you a simple way to diversify your portfolio. But before you assume that just any ETF will do the diversification trick, be sure you look closely at exactly what you're buying.
Drilling down on diversification
With broad-based ETFs, a diversified set of holdings is pretty much assured. The well-known SPDR S&P 500 ETF owns all of the stocks in the S&P 500, and although it's weighted by market capitalization, none of its components has a weighting of more than 3%. You can find similar broad-based index ETFs for other major asset classes and subclasses, including small-cap domestic stocks and international stocks.
But as ETFs have become more specialized, it's a lot easier to find funds that include far fewer stocks among their holdings. With extremely specialized ETFs, you'll often run into situations in which just a few different stocks dominate the fund's portfolio. That can leave you exposed to risk that you might not have been aware of -- or ever wanted to take on.
Pick a country, any country
You can find a good example of this concentration problem in some single-country ETFs. These funds are designed to give investors quick access to stocks of a particular country. They make it easy to tailor your international exposure to focus on the part of the world that interests you the most.
But with many countries, there simply aren't enough big companies to give you a diversified portfolio. For instance, within the iShares MSCI Spain ETF (NYSE: EWP), you'll find Banco Santander (NYSE: STD) making up a whopping 22% of its assets. Given that the banking industry in Spain could end up at ground zero should problems in Greece spread across Europe, investors need to understand the concentrated risk that the ETF is giving its shareholders right now.
You'll find similar problems in emerging markets. The iShares MSCI Brazil ETF (NYSE: EWZ) has nearly 40% of its assets tied up in various share classes of just two companies: Petroleo Brasileiro and Vale.
Even among the countries with the largest economies, you can run into concentration problems. The iShares MSCI UK ETF (NYSE: EWU), for instance, has taken a huge hit partly because of the performance of BP (NYSE: BP). BP's involvement in the Gulf oil spill has spooked investors, and the stock has lost 14% of its value since the rig explosion. BP makes up 8% of the iShares ETF's holdings, so it too has felt an impact, as it's down more than 10%. Similarly, recall-ravaged Toyota Motor (NYSE: TM) tops the holdings list of the iShares Japan ETF, with a 5% position. When Toyota stock dropped more than 20% following its pedal recall in late January, it helped contribute to a 4% drop for the ETF.
How to handle risk
Just because these ETFs have concentrated positions doesn't mean that they're automatically bad investments. Over the past year, for instance, several single-country ETFs have put up strong results -- largely because they were highly concentrated in stocks that ended up doing extremely well. Concentration, and the risk that accompanies it, can work in your favor during bull markets.
Given the higher risk involved, however, what you should do is carefully consider how much money you want to put into any one focused ETF. Whether you're looking at an ETF that covers a small geographical area or a niche-sector ETF, the greater the focus, the more risk there is. If you want to make that kind of big bet on a particular investing theme, then these ETFs can be exactly what you're looking for.
In general, though, you should use focused ETFs only in moderation. You'll get a much smoother ride if you do.
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