February 26, 2011

A Different Aspect of ETF Risk

Exchange Traded Funds (ETFs) have been all the rave.  Ongoing investor interest has prompted an amazing growth of this type of investment vehicle. For most individual investors the traditional ETFs do provide an easy, certainly more cost effective way of diversification and therefore spreading risk among possibly several hundred companies. Many of these ETFs track the major stock market indices such as the SPDR S&P 500 (Ticker: SPY), SPDR Dow Jones Industrial Average (DIA) and Powershares NASDAQ 100 (QQQQ).

I have been repeatedly critical of some of the more complex ETFs in the past.  Leveraged ETFs (double and triple) as well as inverse ETFs should only be considered by more experienced investors as they generally incur much higher risks.  Worse yet, they tend to do a rather poor job at tracking the underlying index or basket of assets, often lagging far behind the expected performance.  We discussed this in detail in numerous articles, more recently in Na├»ve expectations versus actual performance.

By contrast, as long as one invests in the traditional ETFs tracking just the major market indices, one should take comfort from the fact that diversification through the many different companies provides some insurance against individual company risk.  Or does it?

Let’s look at an area of risk that’s not all that obvious on first glance: concentration risk.

Whenever I examine a new ETF or Mutual Fund, my first question is always:  What are they actually buying and what are their current holdings?

One should do the same before buying any index fund too.  Be aware of what the index is actually made of and what the fund allocations are.  For instance, looking at the top ten holdings of the Dow Jones ETF (DIA), it is clear that a significant portion of that index, about 10%, is allocated to one company – IBM.  Nothing against IBM, but just be aware that this is quite a large allocation in just one stock. 

DIA Top Ten Holdings as of 2-25-11
Components Weight
IBM 10.08%
Chevron 6.39%
Caterpillar Inc 6.30%
3M Co 5.64%
Exxon Mobil 5.39%
United Technologies 5.18%
Mcdonalds 4.71%
Boeing Co 4.43%
Coca Cola Co 4.00%
Procter & Gamble Co 3.95%

Granted that the Dow is only made up of 30 companies, that concentration risk is still relatively benign.  Much more of a concentration risk has been gathering steam in the NASDAQ 100.  The extremely successful company Apple now comprises more than one fifth of the Index, clearly a huge allocation in just one company.

QQQQ Top Ten Holdings as of 2-25-11
Components Weight
Apple Inc. 20.47%
QUALCOMM Inc. 5.29%
Google Inc. 4.24%
Microsoft Corp. 3.59%
Oracle Corp. 3.17%
Amazon.com Inc. 2.43%
Intel Corp. 1.96%
Cisco Systems Inc. 1.70%
Comcast Corp. 1.68%
Teva Pharmaceutical 1.68%

Apple has been a huge success no doubt and the NASDAQ 100 Index has also been profiting from Apple’s stellar performance in recent years.  Without going into detail as to how the component allocation of these indices are calculated, the average investor should at least be aware of the top 10 holdings of these ETFs as they provide some insight into how much or how little the index is actually diversified.  Given the larger allocation of Apple in this case has been a huge plus for holders of QQQQ.  But the same holders should appreciate that there is a significant concentration risk through this massive holding in just one company.   Don’t get me wrong, I love Apple and its products and I am not here to argue as to whether Apple’s astronomical market cap of $320 billion is justified.  But the fact that Apple is now more than 20% of the NASDAQ 100 leaves me a bit uncomfortable. 

You could consider buying Apple stock directly (if Apple were the “chosen one”) while achieving your desired level of diversification through a broader index like the S&P 500. In that index comprised of 500 companies, Apple is still the second largest component stock. However, with a weight of just 2.65% it looks more like diversification is actually happening.

SPY Top Ten Holdings as of 2-25-11
Components Weight
Exxon Mobil 3.65%
Apple Inc. 2.65%
General Electric Co 1.85%
Chevron Corp New 1.73%
Microsoft Corp 1.70%
IBM 1.68%
Jpmorgan Chase & Co 1.51%
Procter & Gamble Co 1.49%
Johnson & Johnson 1.39%
Wells Fargo & Co New 1.39%

Again, I’m not debating the commercial viability of Apple Inc. (although there are those who fear that the absence of Steve Jobs will eventually hurt the long-term prospects of the company). This is rather a heads up for those who might not realize how much of their money is invested in just one stock when they purchase shares in the ETF QQQQ.  Always good to know what’s inside the shopping bag…

No comments: