Sound Advice: February 22, 2023

Always Look at Underlying Fund Holdings

It seems easy enough to look at the name of a mutual fund or exchange-traded fund and assume what kinds of stocks are held by the fund.  But in more than a few cases, that assumption could prove costly.  A common example of this would be mutual funds that are labeled “aggressive”.  That’s a label that one would think suggests the likelihood of above average potential for gains.  More likely, however, it means the fund holds stocks that are highly volatile.  In weak markets, they will probably fall farther; in strong markets, they might rise faster.  But the greater likelihood is that the label is a marketing gimmick for underlying holdings that are relatively benign.

There is another wrinkle of greater concern.  That’s the tendency of some investors to buy a number of large, well-known funds to provide what they believe will be diversification.  At first glance, that would seem to make sense.  The problem, however, is that as fund assets grow, the universe of widely traded stocks narrows.  Why? Because funds running billions of dollars have to focus on stocks with good liquidity, i.e., hundreds of thousands of shares daily.  So as their asset bases get bigger, they end up buying many similar stocks.  The net result is that the investor who buys a bunch ends up holding funds with numerous duplications.  And the hoped-for diversification is not achieved.

A third concern is the prevalence of lopsided holdings.  QQQ, for example, which is the Invesco QQQ Trust, has almost 30% of its assets in Apple, Microsoft, and Amazon.  SPY, the SPDR S&P 500 ETF, has more than 20% concentrated in Apple, Microsoft, Amazon, Meta (Facebook), and Alphabet. Then there’s IHF, iShares U.S. Healthcare Providers ETF, which has 37% of its assets in United HealthCare, CVS, and Anthem.  And, no surprise, there are others of this ilk.

The hitch here is that instead of getting diversification, you end up with heavily biased funds that bring with them the considerably increased risk that you tried to avoid by not buying individual stocks.

One approach to sidestep this problem would be to consider ETFs with equal-weighted underlying holdings.  For the S&P 500, an alternative would be RSP, Invesco S&P 500 Equal Weight ETF.  For technology, one could consider RYT, Invesco S&P 500 Equal Weight Technology ETF. The underlying holdings of both of these do indeed offer broad and evenly distributed access to the stock segments they represent.

 

N. Russell Wayne, CFP^Ò

203-895-8877

Any questions?  Please contact me at nrwayne@soundasset.com