Funds Show Major Overlap, Costing Investors
Many investors believe they are building a strong, diverse portfolio by buying popular Exchange Traded Funds (ETFs). However, a closer look reveals a common mistake: buying funds that hold many of the same stocks. This overlap means investors might be paying extra fees for very little added benefit, essentially owning the same assets multiple times.
Understanding Fund Overlap
Consider the example of buying a total stock market fund, an S&P 500 ETF, and the QQQ ETF, which tracks the Nasdaq 100. While these funds are often seen as core holdings, they can have significant overlap. For instance, comparing a total stock market fund (like VOO) with the QQQ ETF shows a substantial overlap. According to data from ETF Research Center, these two funds can share about 50% of their holdings by value. More striking is that 87% of the stocks in QQQ are already present in VOO, given QQQ holds only 104 stocks.
QQQ and Broad Market Funds
QQQ is known for its focus on technology companies. A broad market fund, on the other hand, aims to represent the entire stock market. If an investor intentionally wants this tech-heavy exposure alongside a broad market investment, this overlap might be acceptable. Understanding this concentration is key to knowing what you own.
The S&P 500 Similarity
The issue becomes more pronounced when investors buy funds that are virtually identical. For example, buying both a total stock market fund and an S&P 500 ETF (like SPY) can lead to extreme overlap. Data shows that these two types of funds can have as much as 99% overlap in their holdings. This means an investor paying fees for two separate funds is essentially getting exposure to almost the exact same set of stocks.
Expense Ratios and Diversification
When investors buy funds with high overlap, they are not truly diversifying their investments. Diversification means spreading your money across different types of assets or companies to reduce risk. Buying similar funds doesn’t achieve this goal. Instead, it leads to paying multiple ‘expense ratios.’ An expense ratio is a fee charged by a fund company each year to manage the fund. Paying two or more expense ratios for nearly the same investment means more of an investor’s returns go towards fees rather than growing their wealth.
What Investors Should Know
It is crucial for investors to understand the composition of their portfolios. Before adding new funds, check for overlap. Tools like ETF Research Center can help visualize this. If the overlap between two funds is consistently above 80% or 90%, it signals that you might be paying for the same investment twice. While some overlap is natural, excessive overlap undermines the goal of diversification and increases costs.
Market Impact and Long-Term Implications
For the broader market, this trend highlights a widespread lack of understanding about how ETFs work and how to build a truly diversified portfolio. Investors who are over-concentrated in certain stocks due to fund overlap are exposed to higher risk if those specific stocks or sectors perform poorly. Over the long term, these unnecessary fees can significantly eat into investment returns. For example, a small difference in annual fees can compound over decades, leading to hundreds of thousands of dollars less in retirement savings.
Building a Smarter Portfolio
Investors should aim to build portfolios where each fund adds unique value and contributes to genuine diversification. This might involve choosing funds with lower overlap or selecting asset classes that are not highly correlated. Understanding the specific holdings within each ETF is the first step. By being mindful of fund overlap, investors can avoid paying redundant fees and create a more efficient, cost-effective investment strategy.
Source: A common investing mistake 👀 (YouTube)
