How Diversified Are Small Cap ETFs?


So are small cap ETFs really that diversified? Keep reading to find out.

Investing all of your capital in only a few equities is rarely a sound investment strategy. During the .com bubble of the late 90s both retail and institutional investors were throwing their money into a basket of companies that were posting massive returns. Depending on when they got out, some did very well while others lost it all when the bubble eventually popped. It’s not as if the idea of having a diverse portfolio of stocks in a variety of industries came out after that – the truth is it has been around for ages. Nonetheless, investors enjoy flocking to the high-flying sectors ignoring high evaluations for the possibility of huge returns.

Building a diversified portfolio can be expensive – picking 15-20 stocks and regularly adding to them and rebalancing them based on performance can lead to a hefty bill for trading fees. Instead, many investors look to ETFs to achieve that same level of diversification at a much lower cost. ETFs can be as broad-based as the entire ASX or as narrow as a particular industry. While on the surface this type of investment appears to be the ideal choice for those seeking diversity in actuality the risk may not be spread as far across industries as you might expect.

Take, for example, the SPDR S&P/ASX 200 ETF (ticker symbol STW). This fund invests in the 200 companies that make up the ASX 200 however it does not invest equally among them. Currently, as of October 3, 9.5% of the assets in the fund are invested in Commonwealth Bank of Australia, 7.4% in Westpac Banking Corp and 6.1% in National Australian Bank Ltd. Do you notice anything interesting about the top three holdings? Well, they are all in financials. In fact, financials currently make up 39% of the fund! In total, the top 10 holdings of the 200 represent 51% of the total assets of the fund. This in part has been a result of the recent plunge in commodities stocks as the nominal value of these stocks has dropped relative to the financials.

The same is true for Small Cap ETFs like the iShares Russell 2000 Index ETF. Given the huge number of Biotech stock IPOs these companies have made up a larger chunk of the fund. Basic Materials, Consumer Defensive, Utilities and Energy represent a combined 14% of the holdings – this might not be the kind of diversity investors are looking for as they are taking on more exposure in Healthcare (15%), Consumer cyclical (14%) and Technology (16%). We aren’t necessarily saying you shouldn’t invest in these sectors – if you have done your research, understand these industries well and feel that there is solid growth potential then an investment is definitely merited. Nonetheless it’s important to know exactly what stocks you are investing in and what the weighting is of each sector. Make sure you are comfortable with the risk you are taking on.

Michael Smith

Global Market Review How to Capitalize on Market Volatility