What is considered high ETF overlap?

Understanding High ETF Overlap💡 Definition:When multiple ETFs or funds in your portfolio hold the same stocks, creating unintended concentration risk.: What It Means and How to Manage It

Investing in Exchange-Traded Funds (ETFs) has become a popular strategy for diversifying portfolios and spreading risk. However, ETF overlap — when multiple ETFs hold many of the same stocks — can undermine these benefits. Understanding what constitutes "high overlap" is crucial for making informed investment decisions. In this article, we'll explore what high ETF overlap is, why it matters, and how you can manage it effectively.

What is High ETF Overlap?

ETF overlap occurs when two or more ETFs 💡 Definition:Equity represents ownership in an asset, crucial for wealth building and financial security.share💡 Definition:Stocks are shares in a company, offering potential growth and dividends to investors. the same underlying securities. While some overlap is inevitable, particularly among ETFs that track similar indices, a high level of overlap can reduce diversification💡 Definition:Spreading investments across different asset classes to reduce risk—the 'don't put all your eggs in one basket' principle. benefits and increase concentration risk. Generally, an overlap of more than 30-40% is considered significant, with levels above 70% indicating high overlap.

Why High Overlap Matters

• Reduced Diversification: One of the primary reasons to invest in ETFs is to diversify your portfolio. High overlap means that instead of spreading your risk across different assets💡 Definition:Wealth is the accumulation of valuable resources, crucial for financial security and growth., you might be investing in the same companies multiple times.
• Increased Concentration Risk: Overlapping holdings often include large-cap stocks like Apple, Microsoft, and Nvidia. While these companies are considered stable, high concentration in a few stocks can lead to increased volatility💡 Definition:How much an investment's price or returns bounce around over time—higher volatility means larger swings and higher risk. if those stocks experience downturns.
• Missed Opportunities for Growth: By concentrating too heavily on certain stocks or sectors, you might miss out on growth opportunities elsewhere.

Measuring ETF Overlap

To assess overlap, investors can use portfolio analysis tools or overlap checkers, which calculate the percentage💡 Definition:A fraction or ratio expressed as a number out of 100, denoted by the % symbol. of shared holdings between ETFs. Here's a simplified example:

From the table, it's clear that the S&P 500 ETF and Total U.S. Market ETF have a high overlap of 80%, primarily because the S&P 500 represents a significant portion of the U.S. market.

Real-World Examples

Consider an investor holding an S&P 500 ETF, a Total U.S. Market ETF, and a Nasdaq 100 ETF. While these ETFs may seem diverse, they often hold the same large-cap tech stocks, leading to significant overlap:

• S&P 500 ETF: Heavy in tech with companies like Apple and Microsoft.
• Total U.S. Market ETF: Includes the entire S&P 500.
• Nasdaq 100 ETF: Overlaps in tech with the S&P 500.

In this scenario, the investor might find their portfolio overly concentrated in tech stocks, inflating risk and reducing diversification.

Common Mistakes and Considerations

Overlap Awareness

• Intentional Overlap: Some overlap can be strategic. For example, an investor may choose both an S&P 500 ETF and a Nasdaq 100 ETF to gain targeted exposure to tech stocks. However, it's crucial to be aware of the resulting concentration.
• Hidden Risks: Overlooking overlap can lead to unexpected risk concentrations. Regular monitoring and adjustments are necessary to maintain a balanced portfolio.

Diversification Strategy

• Combine Complementary ETFs: Instead of choosing ETFs with similar holdings, consider combining those with complementary exposures, such as U.S. large-cap and international small-cap ETFs.
• Set Overlap Thresholds: Aim to keep overlap below 30-40% to ensure meaningful diversification.

Bottom Line

High ETF overlap can undermine your investment strategy by reducing diversification and increasing risk. Use tools to measure overlap, understand your ETFs' underlying holdings, and choose funds with complementary exposures to build a truly diversified portfolio aligned with your financial goals. Regularly monitor your investments to ensure they continue to meet 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 diversification needs. By being proactive and informed, you can maximize the benefits of ETF investing and reduce potential pitfalls.