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?

When building an investment portfolio, one of the key strategies is diversification. Exchange-Traded Funds (ETFs) are popular tools for achieving this due to their ability to provide exposure to a broad range of assets💡 Definition:Wealth is the accumulation of valuable resources, crucial for financial security and growth.. However, a common question arises: should you avoid ETFs with any overlap? While some overlap is unavoidable, understanding how much is too much can significantly impact your diversification strategy and portfolio performance.

Understanding ETF Overlap💡 Definition:When multiple ETFs or funds in your portfolio hold the same stocks, creating unintended concentration risk.

ETF overlap occurs when two or more ETFs hold the same underlying securities. This is particularly common among funds tracking broad indices or popular market sectors. Overlap is not inherently bad, but excessive overlap can reduce diversification benefits, leading to increased risk. Here's a general guideline for managing ETF overlap:

• <40% Overlap: Considered low and generally acceptable for diversification.
• 40–70% Overlap: Moderate; advisable to review and ensure it aligns with your investment goals.
• >70% Overlap: High; suggests redundancy, and it might be worth reconsidering one of the ETFs.

Tools like MarketXLS, Passiv, and ETF Insider can help you calculate and visualize ETF overlap, ensuring your portfolio maintains an optimal balance between diversification and exposure to desired sectors.

Real-World Examples of ETF Overlap

Consider an investor holding both the S&P 500 ETF (IVV) and the Nasdaq-100 ETF (QQQ). In 2023, the overlap between these two funds was often above 50%, due to heavy investments in tech giants like Apple, Microsoft, and Nvidia. This overlap can amplify sector-specific risks, particularly if the technology sector underperforms.

Another example is holding both a U.S. large-cap growth ETF (VUG) and an S&P 500 ETF. Both funds include major companies like Apple and Microsoft, leading to an unintended concentration in these stocks. While having exposure to these high-performing companies can be beneficial, excessive overlap can limit the benefits of diversification.

Common Mistakes or Considerations

When assessing ETF overlap, keep these considerations in mind:

• Intentional Sector Overweighting: Some investors might intentionally overlap to overweight specific sectors they believe will💡 Definition:A will is a legal document that specifies how your assets should be distributed after your death, ensuring your wishes are honored. perform well. This can be a viable strategy but requires careful risk management💡 Definition:The process of identifying, assessing, and controlling threats to your financial security and goals..

• Overlooked Overlap in Mutual Funds💡 Definition:A professionally managed investment pool that combines money from many investors to buy stocks, bonds, or other securities.: Overlap isn't limited to ETFs. Mutual funds and other investment products may exhibit similar redundancy, affecting overall portfolio diversification💡 Definition:Spreading investments across different asset classes to reduce risk—the 'don't put all your eggs in one basket' principle..

• Ignoring Market Conditions: Overlap might be more acceptable during certain market conditions. For instance, if a sector is expected to outperform broadly, intentional overlap could be strategic.

Bottom Line

You don't need to avoid ETFs with any overlap, but monitoring and managing it is crucial. Excessive overlap can lead to unintended concentration risks and diminish the diversification benefits that ETFs aim to provide. Use overlap calculators and portfolio analysis tools to ensure your investment strategy aligns with your 💡 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. and financial goals. By doing so, you can construct a robust portfolio that balances exposure and diversification effectively.

In conclusion, while overlap is a natural aspect of investing in ETFs, understanding and managing it wisely will help you maintain a diversified and resilient investment portfolio.