Some surprises are good. A bigger refund check from the IRS. Free dessert at the end of dinner when you didn't order it. A kiss at the end of a first date when you're not expecting one (forgive me, I'm not yet married). Those are examples of good surprises. Then are the surprises that make people dislike surprises of all kinds. A bill from the IRS. Your dentist telling you need more than a basic checkup. Finding out your ETF gives you too much exposure to one stock and not enough exposure to another. All are examples of surprises you want to take a pass on, but the good news is all are preventable.
Now I can't help you with filing your taxes, nor can I tell you much about proper dental health beyond regular brushing and flossing, but I can help you avoid unpleasant ETF surprises at the hands of over- or under-exposure. In fact, people often ask me what ETFs can be used as replacements for a particular stock and which ETFs are too heavily weighted in a small amount of stocks.
An ETF's holdings is an issue of transparency and transparency is one of the key advantages of ETF ownership. You've probably heard about some of the complex financial instruments that have been the undoing of so many major banks since the onset of the financial crisis. The problem with these instruments is that they were so opaque that even many pros couldn't understand them or what was backing the instrument.
There is no such problem with plain vanilla ETFs. If you're considering buying shares in a traditional long ETF, all you have to do is enter the ticker into Yahoo Finance and you'll see the ETF's top 10 holdings. That's not a bad place to start, but I'm going to introduce you to a better way of researching what's inside of your ETFs and it's simple to implement: Just go straight to the issuer's Web site. On their Web sites, ETF issuers such as iShares, Market Vectors and Vanguard will show you ALL of a particular ETF's holdings and the issuer's Web sites are updated on a more regular basis than other sources.
Alright, that's how we can figure out what stocks comprise an ETF. Now let's talk about why you want to make sure your ETF isn't too heavily concentrated in just a few stocks. ETFs that devote big portions of their weight to just a few stocks or ETF whose top-10 holdings account for a disproportionate percentage of the ETF's weight are good for one thing: Short-term trading. I've said it before and I'll say it again: ETFs useful for both short-term traders AND investors with longer time horizons. That said, if you consider yourself to be a longer-term investor, you'll want to focus on ETFs that are diversified.
What I mean is you'd be well served to find an ETF that has, say 75 or 100 stocks where the largest holding accounts for no more than 5% of the ETF's total weight and the top-10 holdings account for about 30% (or less) of the fund's overall weight. I say this because ETFs that are overweight just one or two stocks are risky bets. Take a look at a couple of charts that I've included to illustrate my point.
The first chart highlights the performance of Intel (Nasdaq: INTC) and Texas Instruments (NYSE: TXN) against the Semiconductor HOLDRs (AMEX: SMH). These two stocks account for more than 42% of SMH's weight. If you had bought SMH at the start of this year rather than Texas Instruments, you'd be better only because the ETF is flat while TI is down. On the other hand, Intel has outperformed the ETF. This is a case where you would've been better off just owning Intel.
Here's a more extreme example of how bad news for just one stock can drag down an entire ETF. Transocean (NYSE: RIG), one of the perceived villains in the Gulf of Mexico oil spill disaster, accounts for almost 16% of the Oil Services HOLDRs (AMEX: OIH). An investor that didn't know this may have thought it was OK to buy shares in OIH following the explosion of the Deepwater Horizon. Wrong. That plan would've kept you from a loss of almost 50% in RIG, but you also would've had to endure some serious pain in holding OIH.
I'm going to give you another tip to avoid ETFs that over-expose you to a small number of stocks: Don't be deceived by an ETF's title. Let me give you two examples. First, the PowerShares QQQ (Nasdaq: QQQQ) may appear to be the right way to get exposure to the Nasdaq 100. In reality, QQQQ is nearly 20% weighted to Apple (Nasdaq: AAPL). Don't get me wrong. Apple is an awesome stock, but QQQQ is not a diverse ETF.
Second, the iShares MSCI Brazil Index Fund (NYSE: EWZ) may lead you to believe that this is an ETF that will give you broad exposure to Brazil. The truth is two stocks, Petrobras (NYSE: PBR) and Vale (NYSE: VALE) account for 36% of the ETF's weight. So go Petrobras and Vale, so goes EWZ.
I'm not saying any of these ETFs are bad ideas. Frankly, I think ETFs like this are great trading vehicles for active traders. That said, if your holding period is more than a couple of days, I say take five minutes to go to an issuer's Web site to learn what you're hard-earned money is really buying you.
Disclosure: No positions