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
You'll find similar problems in emerging markets. The iShares MSCI Brazil ETF
Even among the countries with the largest economies, you can run into concentration problems. The iShares MSCI UK 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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Fool contributor Dan Caplinger loves the "It's a trap!" line from Star Wars and is still rooting for Admiral Ackbar to be Ole Miss's mascot. He doesn't own shares of the companies mentioned in this article. Petroleo Brasileiro is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never hits it into the sand trap.