Should I avoid ETFs with any overlap?

Should I Avoid ETFs💡 Definition:A basket of stocks or bonds that trades like a single stock, offering instant diversification with low fees. with Any Overlap?

You’ve carefully picked two different ETFs, thinking you’re building a diversified portfolio. But what if they're both 70% invested in the exact same stocks? Suddenly, your "diversified" plan looks a lot like putting all your eggs in one high-tech basket.

This is called ETF overlap💡 Definition:When multiple ETFs or funds in your portfolio hold the same stocks, creating unintended concentration risk., and it’s more common than you think. While a little overlap is perfectly normal, knowing how much is too much can be the difference between a resilient portfolio and one that’s accidentally taking on too much risk. In fact, a recent study by Morningstar found that nearly 60% of investors hold at least two ETFs with significant overlap, often without realizing the potential consequences.

Understanding ETF Overlap

ETF overlap is just what it sounds like: two or more of your funds own the same stocks. This happens all the time, especially with ETFs that track big, popular indexes. For example, ETFs tracking the S&P 500 will💡 Definition:A will is a legal document that specifies how your assets should be distributed after your death, ensuring your wishes are honored. naturally hold the same top companies in similar proportions.

It’s not automatically a bad thing. A small amount of overlap can be a natural byproduct of investing in broad market indexes. But if the overlap gets too high, it starts to cancel out the benefits of diversification, leaving you overexposed. Think of it like a traffic light system for your portfolio:

• <40% Overlap: Green light. This is a low level of overlap and generally fine. It suggests your ETFs are providing distinct exposures to different market segments.
• 40–70% Overlap: Yellow light. This is moderate. It’s worth taking a closer look to make sure this concentration aligns with your goals. Analyze which specific holdings are causing the overlap and whether you're comfortable with that level of concentration.
• >70% Overlap: Red light. This is high and suggests your funds are largely redundant. You might want to reconsider holding both, as you're likely paying duplicate fees for the same underlying assets💡 Definition:Wealth is the accumulation of valuable resources, crucial for financial security and growth..

Not sure where you stand? You don’t have to build a giant spreadsheet. Tools like MarketXLS, Passiv, and our own ETF Portfolio Analyzer can calculate your overlap in seconds. These tools typically use sophisticated algorithms to compare the holdings of your ETFs and quantify the degree of overlap. Some even provide visualizations to help you understand the concentration of your portfolio.

Real-World Examples of ETF Overlap

Let's look at a classic pairing many investors own: an S&P 500 ETF (like IVV) and a Nasdaq-100 ETF (like QQQ). It feels like you're covering the broad market and the tech sector, right?

Well, in 2023, the overlap between these two funds often crept above 50%. Why? Because tech giants like Apple, Microsoft, and Nvidia are huge players in both indexes. For example, in late 2023, Apple and Microsoft alone could account for over 20% of both IVV and QQQ. This means your bet on "the market" is actually a massive bet on Big Tech. If that sector has a bad year, your whole portfolio feels the pain. If the tech sector declines by 20%, a portfolio with this level of overlap could see a significantly larger drop than a more diversified one.

Another common example is holding a U.S. large-cap growth ETF (VUG) alongside a general S&P 500 fund (like SPY). Again, you'll find major companies like Apple and Microsoft in both, creating an unintended concentration right at the top of your portfolio. VUG, by its nature, focuses on growth stocks, many of which are also heavily weighted in the S&P 500. This can lead to a situation where your portfolio's performance is overly reliant on the performance of a handful of mega-cap growth companies.

Consider also the overlap between different "ESG" (Environmental, Social, and Governance) ETFs. While these funds aim to invest in socially responsible companies, many of them still hold significant positions in the same large-cap stocks, leading to unexpected overlap and potentially diluting the intended impact of your ESG investments.

Common Mistakes or Considerations

It's not always a simple numbers game. Here are a few nuances to consider before making any changes.

Intentional Sector Overweighting

Sometimes, you might want overlap. This is a more advanced strategy where you intentionally double down on a sector you believe will outperform.

For example, you might hold a broad market ETF but also add a specific clean energy💡 Definition:Energy from sources that naturally replenish themselves and don't run out, such as solar, wind, and hydroelectric power. ETF (like ICLN). You know there's overlap, but you're making a conscious choice to increase your exposure to that industry. Just be sure you understand the added risk. Overweighting a specific sector can lead to higher returns if that sector performs well, but it also exposes you to greater losses if the sector underperforms. Before implementing this strategy, consider the potential downside and whether you have the 💡 Definition:Risk capacity is your financial ability to take on risk without jeopardizing your goals.risk tolerance💡 Definition:Your willingness and financial ability to absorb potential losses or uncertainty in exchange for potential rewards. to handle it.

Overlooked Overlap in Mutual Funds💡 Definition:A professionally managed investment pool that combines money from many investors to buy stocks, bonds, or other securities.

Don't forget about your 401(k) or other accounts! Overlap isn't just an ETF problem. Your mutual funds can hold the same big-name stocks, quietly concentrating your risk without you realizing it. Many target-date funds, for example, invest in a mix of underlying funds that can have significant overlap with each other.

To assess overlap in your retirement💡 Definition:Retirement is the planned cessation of work, allowing you to enjoy life without financial stress. accounts, review the fund fact sheets or prospectuses for each mutual fund you hold. Look for the top 10 holdings and compare them across your different funds. You can also use online tools to analyze the overlap between mutual funds, although the availability of such tools may be limited compared to ETF overlap analyzers.

Ignoring Market Conditions

Context is everything. When a sector is booming, high overlap can feel great—your returns are supercharged! The real test comes when the market turns. That's when over-concentration can lead to steeper losses than you anticipated. For example, during the tech boom of the late 1990s, many investors saw their portfolios soar due to heavy exposure to technology stocks. However, when the bubble burst, those same portfolios experienced devastating losses.

Before making any investment decisions based on overlap analysis, consider the current market environment and your investment time horizon💡 Definition:The period until an investment goal is reached, influencing risk and strategy.. If you're a long-term investor, you may be willing to tolerate higher levels of overlap in certain sectors that you believe will perform well over the long run. However, if you're approaching retirement, you may want to reduce your exposure to concentrated positions to protect your capital.

The Impact of Expense Ratios

Holding multiple ETFs with significant overlap can also lead to higher overall expense ratios. You're essentially paying twice (or more) for the same underlying assets. While the expense ratio💡 Definition:The annual fee charged by mutual funds and ETFs, expressed as a percentage of your investment. of a single ETF may seem small, the cumulative effect of multiple overlapping ETFs can add up over time and erode your returns.

Before investing in multiple ETFs, compare their expense ratios and consider whether the potential benefits of diversification outweigh the additional costs. In some cases, it may be more cost-effective to consolidate your holdings into a single, broader-based ETF with a lower expense ratio.

Finding Your Overlap Sweet Spot

So, do you need to hunt down and eliminate every last bit of overlap? Absolutely not. But you can't afford to ignore it, either. Aim for informed diversification, not necessarily maximum diversification.

Excessive overlap creates blind spots in your portfolio, exposing you to concentration risks that undermine the very reason you chose ETFs in the first place. The key is to be aware and intentional with your investment choices.

The first step is simply knowing your numbers. Use an ETF overlap calculator to see where you stand. From there, you can make informed decisions that truly align with your risk tolerance and long-term financial goals. Consider these steps:

1. Identify Your ETFs: List all the ETFs in your portfolio.
2. Use an Overlap Tool: Input your ETFs into an online overlap analysis tool.
3. Analyze the Results: Pay💡 Definition:Income is the money you earn, essential for budgeting and financial planning. attention to the percentage of overlap and the specific holdings that are causing it.
4. Assess Your Risk Tolerance: Determine whether the level of overlap aligns with your risk tolerance and investment goals.
5. Make Adjustments (if needed): If the overlap is too high, consider reducing your exposure to one or more of the overlapping ETFs or reallocating your assets to other asset classes💡 Definition:A group of investments with similar behavior, risk, and regulatory profiles (e.g., stocks, bonds, cash)..
6. Regularly Review: Revisit your portfolio's overlap periodically, especially after making changes to your investment strategy or when market conditions change.

Key Takeaways

• Overlap is Common, but Not Always Bad: A small amount of ETF overlap is normal, especially with broad market ETFs.
• High Overlap Reduces Diversification: Excessive overlap can concentrate your risk and undermine the benefits of diversification.
• Use Overlap Analysis Tools: Utilize online tools to quantify the overlap in your portfolio and identify potential areas of concern.
• Consider Your Risk Tolerance: Ensure that the level of overlap aligns with your risk tolerance and investment goals.
• Be Intentional with Sector Overweighting: If you intentionally overweight a specific sector, understand the added risk and potential downside.
• Don't Forget Mutual Funds: Assess overlap in your 401(k) and other accounts that hold mutual funds.
• Context Matters: Consider market conditions and your investment time horizon when analyzing overlap.
• Monitor Expense Ratios: Be mindful of the cumulative effect of expense ratios when holding multiple overlapping ETFs.
• Regularly Review Your Portfolio: Revisit your portfolio's overlap periodically to ensure it remains aligned with your investment strategy.