Investors increasingly have turned to index ETFs as a way to build diversified equity portfolios quickly and cheaply. However, many of these ETFs are much less diversified, and thus much riskier, than most investors assume. The reason is that a large proportion of the underlying portfolios held by these funds are concentrated in hot mega cap stocks, such FAAMG group members Facebook Inc. (FB), Apple Inc. (AAPL), Amazon.com Inc. (AMZN), Microsoft Corp. (MSFT), and Google parent Alphabet Inc. (GOOGL).
Among the ETFs that have large concentrations of these stocks include the Invesco QQQ Trust (QQQ), the Vanguard S&P 500 Growth ETF (VOOG), the iShares Russell 1000 ETF (IWB), the Schwab U.S. Large-Cap Growth ETF (SCHG), and the Vanguard Mega Cap Growth ETF (MGK), per a detailed report in The Wall Street Journal. For many ETF investors, the upshot is that “you’re taking on additional risk, but it’s not necessarily going to get you higher returns,” as Alex Bryan, director of passive strategies research at fund analysis and rating firm Morningstar Inc., told the Journal.
Significance for Investors
The issue is that indexes tracked by many ETFs, such as those listed above, are capitalization weighted. As the value of a stock rises, so does its market capitalization. The fastest-rising stocks thus will become larger components of the indexes to which they belong. The sponsors of ETFs linked to these indexes will have to rebalance their portfolios, giving increasingly greater weight to these hot stocks with the largest market caps.
For the broad-based SPDR S&P 500 ETF Trust (SPY), which tracks the entire S&P 500 Index (SPX), the five FAAMG stocks collectively accounted for 15.95% of its value as of Sept. 9, 2019, per ETF.com. For the other supposedly diversified ETFs listed above, the figures were, per the same source: QQQ, 44.57%, VOOG, 22.70%, IWB, 14.42%, SCHG, 26.07%, and MGK, 36.23%.
The Securities and Exchange Commission (SEC) is concerned about this development. By federal law, a fund that markets itself as “diversified” cannot have more than 5% of its portfolio in the shares of a given stock, per Zacks.com. The QQQ, VOOG, SCHG, and MGK ETFs all fail this test, since they have portfolio allocations of 5% or more, sometimes much more, in each of several FAAMG stocks. The SEC recently advised index-linked ETFs and mutual funds that they must warn investors if any positions in their portfolio exceed the 5% limit.
Among the risks with ETFs whose portfolios have become concentrated in a few hot mega cap stocks is that a drop in the value of one or more of these holdings can inflict serious damage on overall performance. One alternative for risk-averse investors is to consider the growing number of so-called smart beta ETFs that seek to build in some downside protection, an article in ETF.com suggests.
The Vesper U.S. Large Cap Short-Term Reversal Strategy ETF (UTRN) buys beaten-down low volatility stocks that are less likely to suffer during the next surge in volatility. The Innovator S&P 500 Buffer ETF--July (BJUL) is designed to limit the investor's downside exposure should the S&P 500 fall, in exchange for limiting upside potential if it rises. The Invesco S&P 500 Downside Hedged Portfolio (PHDG) uses VIX Index futures to limit downside exposure to the S&P 500, given that the value of VIX futures tends to spike when the S&P 500 drops significantly.